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Insurance Basics

Risk, hazards, perils, types of insurers, agent authority, and how insurance is regulated. The vocabulary in this section shows up across the whole exam.

Study questions and answers

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1. A risk that involves only the chance of loss, with no chance of gain, is a:

  1. Speculative risk
  2. Morale hazard
  3. Pure risk
  4. Dynamic risk
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C. Pure risk
Only pure risks are insurable. Speculative risks, such as gambling or investing, involve a chance of gain.

2. The cause of a loss, such as fire, illness, or death, is called a:

  1. Hazard
  2. Peril
  3. Risk
  4. Exposure
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B. Peril
A peril is the cause of loss. A hazard is a condition that increases the chance that a peril will cause a loss.

3. An insured who becomes careless because they know they have insurance creates a:

  1. Moral hazard
  2. Physical hazard
  3. Speculative risk
  4. Morale hazard
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D. Morale hazard
Morale hazard comes from indifference or carelessness. Moral hazard comes from dishonesty or a character defect.

4. An applicant with a history of filing fraudulent claims presents a:

  1. Moral hazard
  2. Physical hazard
  3. Morale hazard
  4. Pure risk
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A. Moral hazard
Moral hazard is tied to an individual's dishonesty or character.

5. Buying an insurance policy is an example of which risk management technique?

  1. Reduction
  2. Avoidance
  3. Retention
  4. Transfer
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D. Transfer
Insurance transfers the financial consequences of a loss from the insured to the insurer.

6. A person who quits smoking to lower their chance of developing heart disease is practicing risk:

  1. Avoidance
  2. Transfer
  3. Reduction
  4. Sharing
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C. Reduction
Reduction lowers the chance or severity of a loss without eliminating it. Avoidance means not taking on the risk at all.

7. The law of large numbers states that:

  1. The larger the group of similar risks, the more accurately losses can be predicted
  2. Large insurers always charge lower premiums
  3. Insurers should only accept large policies
  4. Losses become less likely as more people buy coverage
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A. The larger the group of similar risks, the more accurately losses can be predicted
Insurers rely on large pools of similar exposures to predict losses and set premiums.

8. The tendency of people with a higher-than-average chance of loss to seek insurance more often than others is called:

  1. Underwriting
  2. Adverse selection
  3. Morale hazard
  4. Risk retention
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B. Adverse selection
Underwriting exists largely to protect the insurer against adverse selection.

9. An insurer that is owned by its policyholders and may return surplus to them as dividends is a:

  1. Lloyd's association
  2. Mutual insurer
  3. Stock insurer
  4. Reciprocal exchange
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B. Mutual insurer
Mutual insurers typically issue participating policies. Stock insurers are owned by stockholders.

10. A nonprofit organization with a lodge system that provides insurance to its members is a:

  1. Reciprocal exchange
  2. Stock insurer
  3. Risk retention group
  4. Fraternal benefit society
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D. Fraternal benefit society
Fraternals sell insurance only to their members and operate through lodges or chapters.

11. An insurer incorporated in Ohio that sells policies in Pennsylvania is considered what type of insurer in Pennsylvania?

  1. Domestic
  2. Alien
  3. Foreign
  4. Surplus lines
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C. Foreign
A foreign insurer is incorporated in another state. An alien insurer is incorporated in another country.

12. An insurer organized under the laws of another country is a(n):

  1. Alien insurer
  2. Domestic insurer
  3. Foreign insurer
  4. Unauthorized insurer
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A. Alien insurer
Domestic means this state, foreign means another state, and alien means another country.

13. An insurer that has received a certificate of authority to do business in a state is:

  1. Nonadmitted
  2. Authorized (admitted)
  3. Unauthorized
  4. Surplus lines
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B. Authorized (admitted)
A certificate of authority makes an insurer admitted in that state.

14. When an insurer transfers part of its risk to another insurer, the arrangement is called:

  1. Coinsurance
  2. Coordination of benefits
  3. Reinsurance
  4. Subrogation
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C. Reinsurance
The insurer that transfers the risk is the ceding company. The insurer that accepts it is the reinsurer.

15. Authority that the public reasonably believes an agent has, based on the insurer's conduct, is:

  1. Apparent authority
  2. Implied authority
  3. Express authority
  4. Binding authority
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A. Apparent authority
Apparent authority can bind the insurer even though it was never granted in writing.

16. The voluntary giving up of a known right is called:

  1. Subrogation
  2. Concealment
  3. Estoppel
  4. Waiver
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D. Waiver
Estoppel is the legal doctrine that can then prevent the party from reasserting the right it waived.

17. An insurer accepts late premiums several times without objection, then tries to cancel the policy for a late payment. A court may prevent the cancellation under the doctrine of:

  1. Indemnity
  2. Estoppel
  3. Utmost good faith
  4. Adhesion
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B. Estoppel
Estoppel prevents a party from denying a right it previously waived through its conduct.

18. Errors and omissions insurance protects an agent against losses from:

  1. Theft of premiums by an employee
  2. The agent's own disability
  3. Negligent acts or mistakes in performing professional duties
  4. The insurer becoming insolvent
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C. Negligent acts or mistakes in performing professional duties
E&O coverage protects agents against professional liability claims.

19. Which federal law confirmed that the states have primary authority to regulate insurance?

  1. Employee Retirement Income Security Act
  2. Fair Credit Reporting Act
  3. Gramm-Leach-Bliley Act
  4. McCarran-Ferguson Act
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D. McCarran-Ferguson Act
The McCarran-Ferguson Act (1945) left insurance regulation to the states.

20. Which statement about the National Association of Insurance Commissioners (NAIC) is correct?

  1. It drafts model laws for states to consider but has no regulatory authority of its own
  2. It sets premium rates for all insurers
  3. It is a federal agency
  4. It licenses agents in every state
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A. It drafts model laws for states to consider but has no regulatory authority of its own
States can adopt NAIC model laws as written, modify them, or ignore them.

21. A contract signed by someone who was legally intoxicated at the time may be challenged because it lacks:

  1. An offer
  2. Competent parties
  3. Consideration
  4. Legal purpose
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B. Competent parties
Each party must have the legal capacity to enter a contract.

22. A misrepresentation is considered material if:

  1. It is discovered after the policy is issued
  2. It concerns the beneficiary's identity
  3. It was made by the agent
  4. Knowing the truth would have changed the insurer's decision to issue the policy or its terms
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D. Knowing the truth would have changed the insurer's decision to issue the policy or its terms
Only a material misrepresentation gives the insurer grounds to void the contract.
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