Life and Health Insurance License Exam Cram

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International Standard Book Number: 0-7897-3260-2

Library of Congress Catalog Card Number: 2004112114

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First Printing: December 2004

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Contents at a Glance

...............................................

Introduction xxvii Self-Assessment xxxv Chapter 1 Introduction to Insurance 1 Chapter 2 Insurance Regulation 23 Chapter 3 Insurance Law 55 Chapter 4 Underwriting Basics 73 Chapter 5 Group Insurance 91 Chapter 6 Selling Life Insurance 101 Chapter 7 Policy Issuance and Delivery 121 Chapter 8 Types of Insurance Policies 137 Chapter 9 Policy Provisions 177 Chapter 10 Policy Options 205 Chapter 11 Annuities 221 Chapter 12 Group Life Insurance 239 Chapter 13 Social Security and Tax Considerations 247 Chapter 14 Retirement Plans 265 Chapter 15 Health Insurance Basics 281 Chapter 16 Health Insurance Policy Underwriting, Issuance, and Delivery 309 Chapter 17 Health Insurance Policy Provisions 321 Chapter 18 Disability Income Insurance 345

Chapter 19 Medical Expense Insurance 363 Chapter 20 Special Types of Medical Expense Policies 385 Chapter 21 Group Health Insurance 397 Chapter 22 Social Health Insurance 411 Chapter 23 Long-Term Care 433 Chapter 24 Health Insurance Taxation 451 Chapter 25 Practice Exam 1 461 Chapter 26 Answer Key 1 471 Chapter 27 Practice Exam 2 477 Chapter 28 Answer Key 2 487 Appendix A What’s on the CD-ROM 493 Appendix B Need to Know More 497 Glossary 501 Index 527

Table of Contents

...............................................

Introduction...................................................................xxvii

Self-Assessment .............................................................xxxv

Chapter 1 Introduction to Insurance ......................................................1

Risk 2

Perils and Hazards 3

Managing Risk 3

Law of Large Numbers 4

Insurable Interest 5

Insurable Risks 6

Insurance Coverage Concepts 7

Indemnity 7

Limit Of Liability 8

Deductibles 8

Coinsurance 9

Types of Insurance 9

Types of Insurers 10

Commercial Insurers 11

Nonprofit (Service) Organizations 11

Other Types of Private Insurers 12

Self-Insurers 13

The United States Government as an Insurer 13

Domicile and Authorization 14

Insurer’s Domicile (Domestic, Foreign, and Alien Insurers) 14

Authorized Versus Unauthorized (Admitted Versus

Nonadmitted) 15

Types of Distribution Systems 15

Agency System 15

Mass Marketing 16

Internet Insurance Sales 17 Insurance Producers 17

Categories of Producers 17

Exam Prep Questions 19

Exam Prep Answers 22

Chapter 2 Insurance Regulation .........................................................23

Federal Regulation 24 Paul Versus Virginia 24 South-Eastern Underwriters Decision 24 McCarran-Ferguson Act 25 Privacy Act Of 1974 25 Fair Credit Reporting Act 27 False or Fraudulent Statements 30 Financial Services Modernization Act Of 1999 31 Other Regulating Agencies 32 State Insurance Regulation 32 Commissioner’s Scope and Duties 32 Regulating Insurance Companies 33 Insurer Solvency 34 Investments 34 Taxation of Life Insurance Companies 34 Company Ratings 35 Examination of Insurers 35 Guaranty Associations 36 Marketing and Advertising Life and Health Insurance 36 Producer Regulation 37 Licensing Regulation 37 License Required 37 Exceptions To License Requirements 38 Nonresident Producer Licensing 39 Obtaining a License 40 Application for Examination 40 Issuance of License 40 Temporary Agent Licenses 40 Maintaining a License 41 Change of Address 41 Assumed Names 41 Office and Records 41 Continuation, Expiration, and Renewal of License 42 Notice of Appointment 42 Termination of Appointment 43 License Denial, Nonrenewal, or Revocation 43

Table of Contents

Regulated Practices 44
License for Controlled Business Prohibited 45
Unfair Trade Practices 45
Unfair Claims Practices 47
Self-Regulation 49
The NAIC 49
Exam Prep Questions 50
Exam Prep Answers 53

Chapter 3 Insurance Law ..................................................................55

Agency Law 56
Agency Law Principles 56
Formation of a Life and Health Insurance Contract 60
Contract Elements 60
Parts of the Insurance Contract 62
Legal Requirements 63
Contract Construction 63
Contract Characteristics 64
Exam Prep Questions 68
Exam Prep Answers 71

Chapter 4 Underwriting Basics ...........................................................73

The Underwriting Process 74
Selection Criteria 75
Sources of Underwriting Information 75
Field Underwriting 80
Classification of Risks 81
Standard Risks 81
Preferred Risks 82
Determination of Premiums (Rating Considerations) 83
Mortality or Morbidity 83
Interest 84
Expenses 84
Premium Mode 86
Loss Ratios 86
Insurance Fund Reserves 87
Exam Prep Questions 88
Exam Prep Answers 90

Chapter 5 Group Insurance ...............................................................91

Types of Groups 92
Group Premiums 93
Group Underwriting Considerations 93
Adverse Selection 94
Probationary Period 94
Eligibility Period 95
Requirements in Group Underwriting 95
Statutory Requirements 95
Optional Requirements 96
Funding of Group Insurance 97
Exam Prep Questions 98
Exam Prep Answers 100

Chapter 6 Selling Life Insurance .......................................................101

Meeting Consumer Needs 102
The Importance of Insurance 102
Costs Associated with Death 102
Human Life Value Approach 103
Needs Approach 104
Income Periods 104
Capital Conservation and Capital Liquidation 105
Estate Planning 105
Other Sources of Funds 106
Living Benefits 107
Advantages as Property 107
Comparing Insurance Policies 108
Comparative Interest Rate Method 109
Interest-Adjusted Net Cost Method 109
Personal Uses of Life Insurance 110
Charitable Uses of Life Insurance 111
Business Uses of Life Insurance 111
Sole Proprietorship 112
Partnership 112
Corporations 113
Exam Prep Questions 117
Exam Prep Answers 120

Table of Contents xiii

Chapter 7 Policy Issuance and Delivery ..............................................121

Collection of Premium 122 Receipts for Premium 122 Conditional Receipt 122 Binding Receipt 123 Inspection Receipt 124 Temporary Insurance Agreement 124 Submitting the Application and Initial Premium 124 Issuing the Policy 125 Delivering and Servicing the Policy 125 Personal Delivery 125 Mailing the Policy 126 Handling a Claim 126 Payment of Claims 126 Payment Less than Face Amount 127 Producer Responsibilities upon Insured’s Death 128 Policy Replacement 129 Duties of Producers 130 Duties of the Insurer 130 Policy Retention 131 Professionalism and Ethics 131 Fiduciary Responsibility 131 Summary of the Producer’s Responsibilities 132 Exam Prep Questions 133 Exam Prep Answers 135

Chapter 8 Types of Insurance Policies ................................................137

Term Insurance 138
Characteristics of Term Policies 138
Types of Term Policies 139
Advantages and Uses of Term Insurance 141
Disadvantages of Term Insurance 142
Whole Life Insurance 143
Characteristics of Whole Life Policies 143
Types of Whole Life Policies 145
Advantages and Uses of Whole Life Insurance 147
Disadvantages of Whole Life Insurance 147
Flexible Policies 147
Adjustable Life Insurance 147
Universal Life 148

xiv Table of Contents

Variable Life Insurance 151

Variable Universal Life 153

Advantages and Uses of Flexible Policies 154

Disadvantages Of Flexible Policies 154 Industrial Life Insurance 155

Industrial Life Policy Provisions 155 Credit Life Insurance 156

Credit Life Policy Provisions 156 Specialized Policy Forms 157

Endowments 157

Family Income Policies 158

Family Maintenance Policies 159

The Family Policy (Family Protection Policy) 159

Retirement Income Policy 160

Joint Life Policies 160

Juvenile Policies 161

Minimum Deposit Policies 161

Modified Premium Policies 161

Graded Premium Plan 162

Mortgage Redemption 162

Multiple Protection 162

Index-Linked Policies 162

Deposit Term Insurance 163

Pre-need Funeral Insurance 163

Advantages and Uses of Specialized Policies 163

Disadvantages of Specialized Policies 164 Insurance Policy Riders 164

Accidental Death (Double Indemnity) 164

Waiver of Premium 165

Disability Income Rider 167

Payor Rider 168

Guaranteed Insurability 168

Return of Premium 169

Return of Cash Value 169

Cost of Living 169

Additional Insureds 170

Substitute Insured Rider 170 Accelerated Benefits 171

Living Benefit Provisions 171

Viatical Settlements 172 Exam Prep Questions 173 Exam Prep Answers 176

Table of Contents xv

Chapter 9 Policy Provisions .............................................................177

Standard Provisions 178
Insuring Clause 178
Consideration Clause 178
Execution Clause 179
Payment of Premium 179
Ownership Rights 179
Applicant Control or Ownership Clause 180
Grace Period 181
Reinstatement 181
Policy Loan Provisions 182
Automatic Premium Loan Provision 183
Incontestability Clause 183
Suicide Clause 184
Entire Contract 184
Assignment Clause 185
Misstatement of Age or Sex 187
Medical Examinations and Autopsy 188
Modifications Clauses 188
Policy Change Provision (Conversion Option) 189
Free Look 189
Beneficiary Provisions 189
Revocable Versus Irrevocable 190
Succession of Beneficiaries 191
Naming of Beneficiaries 192
Designation Options 192
Class Designations 194
Per Capita and Per Stirpes 195
The Uniform Simultaneous Death Act 196
Spendthrift Clause 197
Facility of Payment Provision 198
Exclusions and Limitations 198
Aviation Exclusion 198
War or Military Service Exclusion 199
Hazardous Occupation or Hobby Exclusion 199
Prohibited Provisions 200
Exam Prep Questions 201
Exam Prep Answers 204

xvi Table of Contents

Chapter 10 Policy Options ................................................................205

Settlement Options 206
Interest Only Option 207
Fixed Period Option 207
Fixed Amount Option 208
Life Income Option 209
Withdrawal Provisions 209
Other Settlement Arrangements 210
Third-Party Rights and Creditor’s Rights 210
Advantages of Settlement Options 211
Nonforfeiture Options (Guaranteed Values) 211
Cash Surrender Value 211
Reduced Paid-Up Insurance Option 212
Extended Term Option 213
Insurance Dividends 213
Policy Dividend Sources 214
Dividend Options 214
Cash Dividend Option 215
Accumulation at Interest Option 215
Paid-Up Additions Option 215
Reduce Premium Dividend Option 216
Accelerated Endowment 216
Paid-Up Option 216
One-Year Term Dividend Option 217
Exam Prep Questions 218
Exam Prep Answers 220

Chapter 11 Annuities ......................................................................221

Purposes of Annuities 222
Distribution of a Lifetime Income 222
Accumulation of a Retirement Fund 222
How Annuities Work 223
The Accumulation Period 223
The Annuity Period 223
Nonforfeiture Options 224
Immediate and Deferred Annuities 225
Deferred Annuity Death Benefits 225
Annuity Premiums 226
Single Premium 226
Level Premium 226

Table of Contents xvii

Flexible Premium 226 Determining Annuity Payouts 227 Variable Annuities 228 Regulation as Securities 228 Accumulation Units 229 Annuity Units 230 Annuity Settlement Options 231 Life Annuities 231 Guaranteed Minimum Payouts 231 Joint Life and Survivorship and Joint Life Annuities 232 Temporary Annuity Certain 233 Two-Tiered Annuities 233 Tax-Sheltered Annuities 234 Retirement Income Annuities 234 Equity-Indexed Annuities 234 Market-Value Adjusted Annuities 235 Exam Prep Questions 236 Exam Prep Answers 238

Chapter 12 Group Life Insurance ........................................................239

Legal Requirements 240
Standard Provisions 241
Certificates of Insurance 241
Policy Forms 242
Dependent Coverage 242
Group Conversion Option 243
FEGLI and SGLI 244
Exam Prep Questions 245
Exam Prep Answers 246

Chapter 13 Social Security and Tax Considerations ..................................247

Social Security 248
Covered Workers 248
Types of Benefits 248
Eligibility for Social Security 248
Insured Status 249
Primary Insurance Amount 250
Normal Retirement Age 250
Dual Benefit Eligibility 251
Retirement Benefits 251
Survivor Benefits 251

xviii Table of Contents

Disability Benefits 252
Maximum Family Benefit 253
Earnings Limit 253
Social Security Payroll Taxes 253
Taxation of Social Security Benefits 254
Income Tax Treatment of Life Insurance 254
Individual Life Insurance 254
Group Life Insurance Proceeds 258
Doctrine of Economic Benefit 258
Federal Estate Tax 259
Charitable Uses of Life Insurance 259
Other Gifts of Life Insurance 260
Transfer for Value Rules 260
Section 1035 Policy Exchanges 261
Business Insurance 261
Exam Prep Questions 262
Exam Prep Answers 264

Chapter 14 Retirement Plans .............................................................265

Qualified and Nonqualified Retirement Plans 266 Vesting Rules 266 Defined Benefits Plans 267 Group Deferred Annuity 267 Individual Deferred Annuity 267 Defined Contribution Plans 268 Profit-Sharing Plans 268 Pension Plans 268 Individual Retirement Accounts and Annuities—IRAs 269 Roth IRAs 271 Savings Incentive Match Plan for Employees (SIMPLE) 271 Simplified Employee Pensions (SEPs) 272 KEOGH Plans 273 Tax-Deferred Annuity Arrangements—403(B) Arrangements 273 Plan Distributions 273 Incidental Limitations 274 Taxation of Plan Benefits 274 Rollovers 275 The Employee Retirement Income Security Act (ERISA) 275 Fiduciary Responsibility 275 Reporting and Disclosure 276 Exam Prep Questions 277 Exam Prep Answers 279

Table of Contents xix

Chapter 15 Health Insurance Basics ....................................................281

Types of Losses and Benefits 282 Loss of Income from Disability 282 Accidental Death and Dismemberment (AD&D) 282 Medical Expense Benefits 282 Dental Expense Benefits 283 Long-Term Care Insurance (LTC) 283 Limited Health Exposures and Insurance Contracts 283 Prescription Coverage 284 Determining Insurance Needs 284 Health Care Providers 285 Health Care Plans 285 Commercial Insurers 285 Blue Cross and Blue Shield 286 Health Maintenance Organizations (HMOs) 287 Federal Requirements 288 HMO Organization 289 Basic and Supplemental Services 291 Important Features Of HMOs 293 Preferred Provider Organizations (PPOs) 295 Point-of-Service Plans 296 Exclusive Provider Organizations (EPOs) 296 Emerging Variations 297 Multiple Option Plans 297 Employer-Administered Plans 297 Self-Funding 297 501(c)(9) Trusts 299 Small Employers 299 Cafeteria Plans 300 Multiple Employer Trusts (METs) 300 Multiple Employer Welfare Arrangements (MEWAs) 300 Other Forms of Group Insurance 301 Blanket Policies 301 Franchise Policies 301 Government Health Insurance 302 Workers Compensation 302 Medicaid 303 TRICARE 304 Exam Prep Questions 305 Exam Prep Answers 307

xx Table of Contents

Chapter 16 Health Insurance Policy Underwriting, Issuance, and Delivery ......309

Underwriting Objectives 310
Premium Payments 310
Definition of Premium 310
Earned and Unearned Premium 310
Payment Modes 311
Initial Premium 311
Policy Effective Date 312
Policy Term 312
Policy Fee 312
Delivering the Policy 313
Servicing the Policy 314
Replacement Policies 314
Professionalism and Ethics 315
Fiduciary Responsibility 316
Summary of the Producer’s Responsibilities 316
Exam Prep Questions 317
Exam Prep Answers 319

Chapter 17 Health Insurance Policy Provisions .......................................321

Mandatory Provisions 322 Required Provision 1: Entire Contract; Changes 322 Required Provision 2: Time Limit on Certain Defenses; Incontestability 323 Required Provision 3: Grace Period 323 Required Provision 4: Reinstatement 324 Required Provision 5: Notice of Claim 325 Required Provision 6: Claim Forms 326 Required Provision 7: Proof of Loss 326 Required Provision 8: Time of Payment of Claims 327 Required Provision 9: Payment of Claims 327 Required Provision 10: Physical Examination and Autopsy 329 Required Provision 11: Legal Actions 329 Required Provision 12: Change of Beneficiary 329 Optional Policy Provisions 330 Optional Provision 1: Change of Occupation 330 Optional Provision 2: Misstatement of Age 331 Optional Provision 3: Other Insurance in This Insurer 331

Table of Contents xxi

Optional Provisions 4 and 5: Insurance with Other Insurers 332 Optional Provision 6: Relation of Earnings to Insurance— Average Earnings Clause 333 Optional Provision 7: Unpaid Premium 334 Optional Provision 8: Cancellation 334 Optional Provision 9: Conformity with State Statutes 335 Optional Provision 10: Illegal Occupation 335 Optional Provision 11: Narcotics 336 Other Health Insurance Provisions 336 The Policy Face 336 Free Look 336 Insuring Clause 337 Consideration Clause 337 Policy Continuation 337 Benefit Payment Clause 339 Preexisting Conditions 339 Nonoccupational Coverage 339 Case Management Provisions 340 Exam Prep Questions 341 Exam Prep Answers 343

Chapter 18 Disability Income Insurance ...............................................345

Financial Planning Considerations 346
Alternatives to Disability Income Insurance 346
Definitions and Benefits 347
Probationary Period 347
Elimination Period 347
Benefit Period 348
Defining Total Disability 348
Presumptive Disability 349
Partial Disability 349
Residual Disability 350
Recurrent Disability 350
Permanent Disability 350
Temporary Disability 350
Confining Versus Nonconfining Disability 351
Accidental Means 351
Definition of Sickness 351

xxii Table of Contents

Types of Disability Benefits 351 Short-Term Disability 352 Long-Term Disability (LTD) 352 Lump-Sum Benefits 352 Disability Exclusions 352 Optional Disability Income Policy Benefits and Riders 353 Rehabilitation Benefit 353 Future Increase Option 353 Cost of Living Benefit 353 Lifetime Benefits 354 Social Security Rider 354 Social Insurance Supplements 355 Additional Monthly Benefit (AMB) Riders 355 Hospital Confinement Rider 355 Impairment Rider 355 Nondisabling Injury Rider 355 Waiver of Premium (with Disability Income) 356 Accidental Death and Dismemberment (AD&D) 356 Other Provisions 356 Business Uses of Disability Income Insurance 357 Business Overhead Expense (BOE) 357 Key Person Disability Insurance 357 Disability Buy-Sell Insurance 358 Disability Reducing Term Insurance 358 Exam Prep Questions 359 Exam Prep Answers 361

Chapter 19 Medical Expense Insurance ................................................363

Basic Medical Expense 364
Hospital Expense Benefits 364
Surgical Expense Benefits 365
Regular Medical Expense Benefits 366
Other Medical Expense Benefits 367
Common Exclusions and Limitations 369
Major Medical Insurance 371
Comprehensive Major Medical Benefits 371
Supplemental Major Medical Benefits 372
Covered Expenses 372
Other Major Medical Concepts 373
Medical Expense Limitations 375
Benefits for Other Practitioners 377
Medical Expense Exclusions 377

Table of Contents xxiii

Optional Features and Benefits 379
Prescription Drugs 379
Vision Care 379
Hospital Indemnity Rider 380
Nursing/Convalescent Home 380
Organ Transplants 380
Exam Prep Questions 381
Exam Prep Answers 383

Chapter 20 Special Types of Medical Expense Policies .............................385

Dental Care Insurance 386
Traditional Dental Coverage 386
Exclusions and Limitations 388
Minimizing Adverse Selection 388
Prepaid Dental Plans 389
Limited Policies 390
Dread Disease 390
Travel Accident Insurance 390
Hospital Income (Indemnity) Insurance 391
Vision Care Insurance 391
Prescription Drug Policies 391
Credit Insurance 392
Notice of Proposed Insurance 393
Credit Life: A Corollary Coverage 393
Exam Prep Questions 394
Exam Prep Answers 396

Chapter 21 Group Health Insurance .....................................................397

Group Health Insurance Policy Types 398 Group Coverage Provisions 398 Conversion Privilege 399 Dependent Coverage 400 Coordination of Benefits Provision 400 Records and Clerical Errors 401 Federal and State Regulations Affecting Group Policies 401 Health Insurance Portability and Accountability Act (HIPAA) 401 Continuation of Benefits (COBRA) 402 Omnibus Budget Reconciliation Act (OBRA) 404 Tax Equity and Fiscal Responsibility Act (TEFRA) 405

xxiv Table of Contents

Employee Retirement Income Security Act (ERISA) 405 Age Discrimination in Employment Act (ADEA) 406 The Americans with Disabilities Act (ADA) 406 Pregnancy Discrimination 406 State Regulation 407 Exam Prep Questions 408 Exam Prep Answers 410

Chapter 22 Social Health Insurance .....................................................411

Medicare 412
Enrollment 412
Benefits Under Medicare Part A 413
What Part A Does Not Cover 415
Benefits Under Medicare Part B 415
What Part B Does Not Cover 418
Claims and Appeals 418
Medicare Supplement Insurance 419
Standardized Medicare Supplement Benefits 419
Core Benefits 419
Optional Benefits 420
Standardized Policy Forms 420
Other Standard Provisions 421
Medicare+Choice 422
Fee-for-Service Plans 422
Health Maintenance Organizations (HMOs) 423
Preferred Provider Organizations (PPOs) 423
Provider-Sponsored Organizations (PSOs) 423
Medicare and Employer Coverage 424
Medicaid 425
Financial Tests 425
Spousal Impoverishment Rule 425
Medicare Cost Assistance 425
Social Security Disability 426
TRICARE 426
Workers Compensation 427
Types of Benefits 427
Compensable Injuries 427
Occupational Diseases 427
Types of Disability 428
Compulsory and Elective Compensation Laws 428
Extraterritorial Provisions 428
Second Injury Funds 429

Table of Contents xxv

Exam Prep Questions 430
Exam Prep Answers 432

Chapter 23 Long-Term Care ..............................................................433

History of LTC Coverage 434
Suitable Purchasers 435
Probability of Needing Care 437
Options Other than Insurance 437
Rating Factors 438
Types of Benefits 438
Common Provisions 439
Eligibility 439
Renewability 439
Premiums 440
Waiver of Premium 440
Prior Hospitalization 440
Care Level 440
Hospice Care 441
Respite Care 441
Home Health Care 441
Adult Day Care 441
Professional Care Advisor 442
Benefit Amount 442
Benefit Periods 442
Exclusions 443
Preexisting Conditions 443
Elimination Period 443
Benefit Triggers 443
Activities of Daily Living (ADL) 443
Cognitive Impairment 444
Medical Necessity 444
Qualified Plans 444
Regulation 445
Emerging LTC Issues 445
Inflation Protection 445
Nonforfeiture Provisions 446
Marketing LTC Coverage 446
Exam Prep Questions 447
Exam Prep Answers 449

xxvi Table of Contents

Chapter 24 Health Insurance and Taxation .............................................451

Social Security Disability Benefits 452 Tax Treatment of Social Security Contributions 452 Health Insurance 452 Individual Policies 452 Group Policies 453 Sole Proprietors and Partnerships 454 Business Policies 454 Disability Insurance 455 Medicare Supplement and Long-Term Care Insurance 455 Exam Prep Questions 457 Exam Prep Answers 459

Chapter 25 Practice Exam 1 ..............................................................461

Chapter 26 Answer Key 1 .................................................................471

Chapter 27 Practice Exam 2 ..............................................................477

Chapter 28 Answer Key 2 .................................................................487

Appendix A What’s on the CD-ROM ......................................................493

Review Questions and Exam Simulator 493
Installing the CD 494
Customer Service and Ordering 495

Appendix B Need to Know More? ........................................................497

Glossary .......................................................................501

Index ............................................................................527

Introduction

...............................................

Welcome to Life and Health Insurance Licensing Exam Cram 2! Whether this is your first or your fifteenth Exam Cram 2 series book, you’ll find information here that will help ensure your success as you pursue knowledge, experience, and certification. This introduction explains state insurance licensing programs in general and talks about how the Exam Cram 2 series can help you prepare for your state insurance licensing exam. Chapters 1 through 19 are designed to remind you of everything you need to know in order to take—and pass—your state insurance licensing exam. The two sample tests at the end of the book should give you a reasonably accurate assessment of your knowledge—and, yes, we provide the answers and their explanations to the tests. Read the book and understand the material, and you stand a very good chance of passing the test.

Exam Cram 2 books help you understand and appreciate the subjects and materials you need to pass state insurance licensing exams. Exam Cram 2 books are aimed strictly at test preparation and review. They do not teach you everything you need to know to pass the exam. Instead, we present and dissect the questions and problems I’ve found that you’re likely to encounter on a test. I’ve worked to bring together as much information as possible about state insurance licensing exams.

Nevertheless, to completely prepare yourself for any state insurance licensing test, we recommend that you begin by taking the Self-Assessment that is included in this book, immediately following this introduction. The Self-Assessment tool will help you evaluate your knowledge base against the requirements for a state insurance licensing exam under both ideal and real circumstances.

Based on what you learn from the Self-Assessment, you might decide to begin your studies with some more comprehensive self-study or classroom training, some practice with state insurance exam simulators, or an audio review program. On the other hand, you might decide to pick up and read one of the many study guides available from third-party vendors on certain topics. We also recommend that you supplement your study program with a visit to your state insurance department’s website to get all the details about

xxviii Introduction

how to get your insurance license as well as how to schedule and take your insurance licensing exam.

Getting an Insurance License

Licensing is the way governments assure that only qualified individuals are allowed to practice certain important professions, such as being an insurance producer. Because insurance is regulated primarily at the state level, the rules for getting an insurance license vary somewhat from state to state.

Every state requires individuals to pass a qualification exam to get an insurance license. In addition, most states require individuals to meet a prelicensing education requirement before they can take the qualification exam. In some states, the prelicensing education requirement can be met through an approved self-study course—that is, you buy a book that has been approved in advance by the state insurance department and take an exam (not to be confused with the licensing qualification exam) that you send in to be graded. In other states, the prelicensing education requirement can be met only by attending an approved classroom course.

This Exam Cram text is not approved to meet the prelicensing education requirement in any state. It is designed only as a supplementary aid to help you pass the state insurance licensing exam.

Besides fulfilling any prelicensing education requirement and passing the licensing exam, insurance license candidates must also submit a license application to their state insurance department and have it approved. In some states, the license application must be submitted before taking the license qualification exam; in some states, it must be submitted after passing the exam. Call your state insurance department’s licensing division or visit its website to find out what you need to do in your state.

About This Book

We structured the topics in this book to build on one another. Therefore, the topics covered in later chapters might refer to previous discussions in earlier chapters. We suggest you read this book from front to back.

After you read the book, you can brush up on a certain area by using the Index or the Table of Contents to go straight to the topics and questions you want to reexamine. We use headings and subheadings to provide outline information about each given topic. After you pass the exam and obtain your insurance license, we think you’ll find this book useful as a tightly focused reference and an essential foundation of insurance information.

Chapter Formats

Each Exam Cram 2 chapter follows a regular structure, with graphical cues about especially important or useful material. The structure of a typical chapter is as follows:

xxxii Introduction

• Opening hotlists—Each chapter begins with lists of the terms you need to understand and the concepts you need to master before you can be fully conversant with the chapter’s subject matter.

• Topical coverage—After the opening hotlists, each chapter covers the topics related to the chapter’s subject.

• Alerts—Throughout the topical coverage section, we highlight material most likely to appear on the exam by using a special Exam Alert layout that looks like this:

This is what an Exam Alert looks like. An Exam Alert stresses concepts or terms that will most likely appear in one or more license exam questions. For that reason, we think any information found offset in Exam Alert format is worthy of special attention.

Even if material isn’t flagged as an Exam Alert, all the content in this book is associated in some way with test-related material. What appears in the chapter content is critical knowledge.

➤ Notes—This book is an overall examination of entry-level insurance knowledge. As such, we touch on many aspects of insurance that open doors for further inquiry. Where a topic goes deeper than the scope of the book, we use notes to indicate areas of concern or further training.

Cramming for an exam will get you through a test, but it won’t make you a fully competent insurance professional. Although you can memorize just the facts you need in order to become licensed, your daily work in the field will rapidly put you in water over your head if you don’t continue your insurance education.

➤ Tips—Besides Alerts and Notes, we also include tips to help you remember or distinguish certain information that may appear on your license exam.

Pay special attention to Tips because they provide you with various techniques that may improve your exam score!

• Exam Prep Questions—This section presents a short list of multiple-choice test questions related to the specific chapter topic. Each question has a following explanation of both correct and incorrect answers. The practice questions highlight the areas we found to be most important on the exam.

• Need to Know More?—At the end of the book is a section titled “Need to Know More?” This section provides pointers to resources that we found to be helpful in offering further details on the book’s subject matter. If you find a resource you like in this collection, use it, but don’t feel compelled to use all these resources. We use this section to recommend resources that we have used on a regular basis, so none of the recommendations will be a waste of your time or money. These resources may go out of print or be taken down (in the case of websites), so we reference widely accepted resources.

Introduction xxxiii

The bulk of the book follows this chapter structure, but there are a few other elements that we would like to point out:

• Practice Exams—The sample tests, which appear in Chapters 25 and 27 (with answer keys in Chapters 26 and 28), are intended to test your comprehension of the material in this book. They are also intended to be in a similar format and degree of difficulty as the questions you are likely to see on the license exam. However, because the questions on the actual exam are kept highly confidential, you should expect that the questions on the actual license exam will be ones that you have never seen before.

• Answer Key—These provide the answers to the sample tests, complete with explanations of both the correct responses and the incorrect responses.

• Glossary—This is an extensive glossary of important terms used in this book.

• Cram Sheet—This appears as a tear-away sheet inside the front cover of this Exam Cram 2 book. It is a valuable tool that represents a collection of the most difficult-to-remember facts, terms, and concepts we think you should memorize before taking the test.

• You might want to look at the Cram Sheet in your car or in the lobby of the testing center just before you walk into the testing center. The Cram Sheet is divided under headings, so you can review the appropriate parts just before each test.
• CD-ROM—The CD contains the BISYS Education Services Exam Simulator, Preview Edition software. The preview edition exhibits most of the functionality of the commercially available version, but offers a reduced number of unit review questions and a 25-question practice exam. To get the complete set of practice questions and 100-question exam functionality, visit www.bisyseducation.com or call 800-241-9095.

xxxiv Introduction

Contacting the Source

Life and Health Insurance Licensing Exam Cram 2 is a real-world tool that you can use to prepare for and pass your state insurance licensing exam. We’re interested in any feedback you would care to share about the book, especially if you have ideas about how we can improve it for future test-takers. We’ll consider everything you say carefully and will respond to all reasonable suggestions and comments. You can reach us via email at customerservice@bisys-education.com.

Let us know if you found this book to be helpful in your preparation efforts. We’d also like to know how you felt about your chances of passing the exam before you read the book and then after you read the book. Of course, we’d love to hear that you passed the exam—and even if you just want to share your triumph, we’d be happy to hear from you.

Thanks for choosing us as your license exam preparation coach, and enjoy the book. We wish you luck on the exam, but we know that if you read through all the chapters and work with the product, you won’t need luck— you’ll pass the test on the strength of real knowledge!

Self-Assessment

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We include a Self-Assessment in this Exam Cram 2 to help you evaluate your readiness to take and pass your state insurance license qualification exam. It should also help you understand what you need to master for an entry-level knowledge of the industry in which you are about to embark on a career.

Onward to Exam and Career Success!

After you’ve undertaken the right studies and reviewed the many sources of information to help you prepare for the license qualification exam, you’ll be ready to take a practice exam. When your scores are positive enough to indicate that you will get through the exam, you’re ready to go after the real thing. Good luck!

Introduction to Insurance

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Chapter 1

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The future is notoriously unpredictable. Every day, each of us faces the possibility that something might happen that would result in a personal financial loss. Sickness, disability, premature death, and damage or loss of property are examples of things that might cause a financial loss. We know that these things will happen to some people and not to others, but we do not know which things will happen to any particular person. In the face of this uncertainty, the idea and business of insurance was developed as a means for spreading the result of a financial loss among many persons, so the cost to any one person is small.

The basic mechanism behind insurance is relatively simple. The insurance company or insurer receives relatively small amounts of money, referred to as premium, from each of the large number of people buying insurance. A large uncertain loss is exchanged for a specific small amount of premium.

The agreement between the insurer and the insured, the person who is covered by the insurance, is established in a legal document referred to as a contract of insurance or a policy. The insurer promises to pay the insured according to the terms of the policy if a loss occurs. Loss is defined as reduction in the value of an asset. To be paid for a loss, the insured must notify the insurer by making a claim. The claim is a demand for payment of the insurance benefit to the person named in the policy.

Risk

To really understand insurance and how it works, you must first understand risk. Risk is the possibility that a loss might occur and is one of the reasons that people purchase insurance.

Notice that risk is not the loss itself, but the uncertainty of loss. There are some losses that are certain to happen eventually, such as when a rug finally wears out after years of use, or the fact that a person will eventually die.

There are two types of risks, only one of which can be covered by insurance:

• Speculative risk is a risk that offers the opportunity for gain as well as the possibility of loss. Gambling is a common type of speculative risk. Insurance is not designed to protect against speculative risks. Examples are found in new business ventures, stock market investments, and race track bets.

• Pure risk is the possibility of loss only and is the type of risk that insurers accept—for example, the possibility of financial loss due to an accident, sickness, or premature death. The purpose of insurance is to make the person whole again, to restore the insured to his or her original financial position. Insurance is not designed to provide a person with the opportunity of making a gain or profit.

Perils and Hazards

A peril is the cause of a potential loss. Accident, fire, explosion, and flood are common perils that may be covered by insurance. A hazard is a condition that increases the seriousness of a potential loss or increases the likelihood that a loss will occur. Slippery floors, unsanitary conditions, and improperly stored gasoline are hazards Four types of hazards may contribute to losses:

• Physical hazards arise from material, structural, or operational features of a risk situation. Slippery floors or unsanitary conditions would be physical hazards.

• Moral hazards arise from people’s habits and values. A moral hazard means that a person might create a loss situation on purpose just to collect from the insurance company. Filing a false claim is an example of moral hazard.

• Morale hazards arise out of human carelessness or irresponsibility. This means that an individual, through recklessness or thoughtless action, can increase the possibility for a loss. Failing to wear a seatbelt while driving is an example of morale hazard.

• Legal hazards arise from court actions that increase the likelihood or size of a loss. Legal hazards are illustrated by the growing tendency of people to file lawsuits and of courts to award enormous sums for alleged damages, or to require insurance payments that were not intended.

Managing Risk

Risks sometimes result in small losses, such as a stubbed toe or lost pocket comb. But risks may also result in serious financial losses, such as when a person is injured in a car accident or contracts a fatal disease. There are four ways of managing risk:.

1. The first method is to avoid risk. For example, a person might avoid the risk of being in an automobile accident by never getting into a car. However, not all risk is avoidable.

Chapter 1

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1. Risk may be reduced, or controlled, by examining the perils and seeing which ones can be eliminated. For example, a person reduces the risk of health problems by living a healthier lifestyle.

2. A risk is retained when a person decides to assume financial responsibility for certain events. The deductible amount on a health insurance policy is one way the insured retains some portion of the risk. In addition the premium may be reduced because he or she retains some of the risk.

3. The final method of managing risk is to transfer the risk to another party. This may be done through any of a number of legal mechanisms, such as hold harmless agreements or lawsuits. However, for many risks, the best way for individuals to transfer them is through insurance.

Multiple methods may be employed simultaneously to manage the same risk. For example, purchasing an insurance policy to cover a significant exposure involves risk transfer; selecting a high deductible in order to reduce premiums involves an element of risk retention.

Law of Large Numbers

When an individual purchases insurance, the risk is transferred from the individual to the insurer. To make a successful business of accepting the transfer of individual risk, the insurer needs to have some idea of how many losses will actually occur.

Insurance companies cannot predict the losses expected for any given individual. However, using the law of large numbers, insurers are able to predict how many losses will occur in a group. The basic principle of this law is that the larger the group, the more predictable the future losses in the group will be for a given time period. The insurance company cannot reliably predict which people will die, but with a large enough population, statistics can accurately predict how many people in the group will suffer a loss. For example, experience might show that out of a group of 100,000 people aged 40, about 325 will die each year.

For the law of large numbers to operate, it is essential that a large number of similar risks, or exposure units be combined. An exposure unit is the item of property or the person insured. The exposure unit in life and health insurance is the economic value of the individual person’s life. In property and casualty insurance it is the number of cars, homes, and so forth.

The degree of error in predicting future losses decreases as the number of individual exposure units in a group increases. Thus, the larger the group, the more closely the predicted experience will approach the actual loss experience. Insurance companies deal only with averages, in the sense of establishing actuarial predictions of loss experience. By providing for the average risk, the extremes in loss experience cancel each other out.

Actuaries are mathematicians who study and compile statistical data regarding exposure units and risks. This data is the basis for mortality and morbidity tables used to predict probable losses due to death (mortality) or sickness (morbidity) of large groups of people.

Insurance companies collect premiums to cover expenses, profits, and the cost of expected losses. The expected losses are based on the past experience of the average risk. The fact that some people never experience an automobile accident or that some live well beyond their life expectancy is immaterial, because other people are involved in accidents or die prematurely. Those insureds who suffer loss are compensated; many other insureds do not experience sizable losses.

Insurable Interest

A basic rule governing insurance states that before an individual can benefit from insurance, that individual must have must have a legitimate interest in the preservation of the life or property insured. This requirement is called

insurable interest.

A person is presumed to have an insurable interest in his or her own life. An individual is also considered to have an insurable interest in the life of a close blood relative or a spouse. In these cases insurable interest is based on the love that individual would have for the family member and a real interest in protecting the life of that family member.

Insurable interest can also be based on a financial loss that will take place if an insured individual dies. Examples are two partners in a business, each of whom brings substantial expertise to that business. If one partner dies, the business could fail, resulting in a loss to the other partner.

For life insurance, insurable interest must exist at the time of the application for insurance, but it need not exist at the time of the insured’s death. In contrast, property and casualty insurance generally requires an insurable interest to exist only at the time of loss.

Insurable interest affects who may purchase a policy, but not who may ben
efit from a policy. For example, an individual could purchase life insurance
on his or her own life and name a charitable organization as the beneficiary.

Chapter 1

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Because every person is presumed to have an insurable interest in his or her own life, the policy would be valid. As another example, a doctor who benefits from medical expense reimbursement payments may not have an insurable interest in the health of the insured, but the policyowner, usually the insured or the insured’s employer, does have a personal or financial interest in keeping the insured healthy.

Insurable Risks

Not all risks are equally insurable. Insurable risks have certain characteristics that make the rate of loss fairly predictable, allowing insurers to adequately prepare for the losses that do occur. The more closely a risk aligns with the following characteristics, the more insurable it is.

Large Numbers of Homogeneous Units

The expected loss experience of a group of exposure units cannot be predicted with any certainty unless there are a large number of exposure units in that group. Risks are not considered insurable unless the insurance company has a large enough number of similar (homogeneous) risks and knows enough about their previous loss experience to be able to reliably predict possible future losses.

Loss Must Be Ascertainable

Because the purpose of insurance is to reduce or eliminate the uncertainty of economic loss, the insurer must be able to place a monetary value on the loss. In life insurance, monetary value is placed on the insured’s human life value or ability to earn an income. In health insurance, economic loss is measured by lost wages or by actual medical expenses incurred. The potential loss must be measurable so that both parties can agree on the precise amount payable in the event the loss occurs.

Loss Must Be Uncertain

Because the purpose of insurance is to reduce or eliminate uncertainty, it is obviously not in the public interest to permit the writing of insurance for intentional acts, such as a man jumping off a skyscraper 2 days after purchasing an insurance policy. Uncertainty arises out of not knowing what is going to happen or being unable to predict what is going to happen to the individual exposure unit. If insurance is provided for certain losses, the element of chance is not a factor. Nor is there any element of uncertainty in losses occasioned by natural wear and tear or deterioration, depreciation, or defects in property covered under insurance.

With life insurance, the uncertainty rests not with whether a certain individual will die, but rather with when that individual will die and what financial obligations will be left behind when death occurs. With health insurance, the uncertainty rests less with whether a certain individual will have an accident or become ill sometime during his or her lifetime, but rather with how much expense will be incurred when an illness or accident occurs.

Economic Hardship

The nature of the loss must be such that an economic hardship would occur should the loss occur. For example, if a person loses 2 days of pay because of an injury, a loss occurs, but it is not significant enough to be covered by insurance.

The nature of the loss must be of such magnitude that it is worthwhile to incur the premium cost to cover potential loss. Thus, a comparison of the potential loss with the cost of premium is a major consideration to the insurance buyer.

Exclusion of Catastrophic Perils

Although the ability to predict future losses with a reasonable degree of accuracy is critical to the insuring function, certain types of perils do not lend themselves to prediction. Such perils, when they cause losses, do not establish a pattern of predictability that can be relied on for future predictions of anticipated loss. Examples of excluded catastrophic perils are war, nuclear risk, and floods.