CFP - Risk Management and Insurance Planning (11% of the exam) - Section C.17

Principles of risk and insurance

Risk management techniques (avoidance, reduction, retention, transfer), the characteristics of insurable risk, adverse selection and moral hazard, insurable interest, indemnity, and the legal principles that govern an insurance contract. Items map a client exposure to the right technique.

Risk management process

Practice question for this objective

Free sampleRisk Management and Insurance Planningmedium

A client applies for a 1,000,000 dollar term life policy on her business partner, whom she would have to buy out under a cross purchase agreement, and at the same time applies for a fire policy on a warehouse she owns. The planner is asked when insurable interest has to be present for each contract to be enforceable. What is the correct position?

AFor both policies, at the time the death or the property loss occurs
BFor the life policy, at the time the policy is applied for; for the fire policy, at the time of the loss Correct
CFor both policies, at the time each contract is issued by the insurer
DFor the life policy, at the time of death; for the fire policy, at the time the policy is applied for

Insurable interest must exist at inception for life insurance and at the time of loss for property insurance. Insurable interest exists to stop insurance being used as a wager. Life insurance pays a stated sum rather than measuring a loss, so the law only asks that a genuine interest existed when the contract was formed; a business partner funding a cross purchase agreement clearly has one. Property insurance is a contract of indemnity, restoring the insured to the position held before the loss and no better, so the insured must hold an economic interest at the moment the loss occurs. This same indemnity principle supports subrogation, under which the insurer that pays a property claim takes over the insured's right to recover from a negligent third party.

Why A is wrong: This applies indemnity logic to both contracts, which is tempting because it seems consistent, but it would void a life policy whenever the relationship ends, and a policy remains enforceable even if the partnership is later dissolved.

Why B is correct: Life insurance requires insurable interest only at inception, because the contract is a valued contract that pays a stated sum, while property insurance is a contract of indemnity, so the interest must exist when the loss happens for there to be a measurable loss to indemnify.

Why C is wrong: This applies the life insurance rule to property, which is a common error, but a person who sells the warehouse before a fire has no economic loss to indemnify and so may not recover under the policy.

Why D is wrong: This reverses the two rules, which is attractive because both timings appear somewhere in the correct answer, but it would defeat the very purpose of funding a buy out where the business relationship may change before death.

See more CFP practice questions, answers explained.

Exam traps in Risk Management and Insurance Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

Adverse selection, because the client is more prone to loss than the average insured in the pool
Why it is wrong: Adverse selection describes the tendency of higher risk applicants to seek insurance more readily than lower risk ones, so it concerns who buys the cover at underwriting; here the client already holds the policy and the issue is how her conduct changed afterwards.
63,000 dollars
Why it is wrong: This divides the 320,000 dollar limit by the full 500,000 dollar replacement cost to get 0.64, applies that to the 100,000 dollar loss and deducts 1,000; the denominator must be the amount of insurance required by the clause, not the whole replacement cost.
450 dollars of each payment is ordinary income for as long as she lives, because the exclusion ratio is fixed when payments begin and applies to every payment she receives.
Why it is wrong: The 450 dollar figure is computed correctly, but the exclusion is capped at the investment in the contract. Once basis is fully recovered the excluded portion ceases and later payments are taxed in full, so treating the ratio as permanent understates her income in every year after the twentieth.

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