From Wikipedia, the free encyclopedia
Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk
of a contingent loss. Insurance is defined as the equitable transfer of
the risk of a loss, from one entity to another, in exchange for a
premium. An insurer is a company selling the insurance. The insurance rate is a factor used to determine the amount, called the premium, to be charged for a certain amount of insurance coverage. Risk management, the practice of appraising and controlling risk, has evolved as a discrete field of study and practice.
Principles of insurance
Commercially insurable risks typically share seven common characteristics.[1]
- A large number of homogeneous exposure units. The vast
majority of insurance policies are provided for individual members of
very large classes. Automobile insurance, for example, covered about
175 million automobiles in the United States in 2004.[2] The existence of a large number of homogeneous exposure units allows insurers to benefit from the so-called “law of large numbers,”
which in effect states that as the number of exposure units increases,
the actual results are increasingly likely to become close to expected
results. There are exceptions to this criterion. Lloyd's of London
is famous for insuring the life or health of actors, actresses and
sports figures. Satellite Launch insurance covers events that are
infrequent. Large commercial property policies may insure exceptional
properties for which there are no ‘homogeneous’ exposure units. Despite
failing on this criterion, many exposures like these are generally
considered to be insurable.
- Definite Loss. The event that gives rise to the loss that is
subject to insurance should, at least in principle, take place at a
known time, in a known place, and from a known cause. The classic
example is death of an insured on a life insurance policy. Fire,
automobile accidents, and worker injuries may all easily meet this
criterion. Other types of losses may only be definite in theory.
Occupational disease, for instance, may involve prolonged exposure to
injurious conditions where no specific time, place or cause is
identifiable. Ideally, the time, place and cause of a loss should be
clear enough that a reasonable person, with sufficient information,
could objectively verify all three elements.
- Accidental Loss. The event that constitutes the trigger of a
claim should be fortuitous, or at least outside the control of the
beneficiary of the insurance. The loss should be ‘pure,’ in the sense
that it results from an event for which there is only the opportunity
for cost. Events that contain speculative elements, such as ordinary
business risks, are generally not considered insurable.
- Large Loss. The size of the loss must be meaningful from the
perspective of the insured. Insurance premiums need to cover both the
expected cost of losses, plus the cost of issuing and administering the
policy, adjusting losses, and supplying the capital needed to
reasonably assure that the insurer will be able to pay claims. For
small losses these latter costs may be several times the size of the
expected cost of losses. There is little point in paying such costs
unless the protection offered has real value to a buyer.
- Affordable Premium. If the likelihood of an insured event is
so high, or the cost of the event so large, that the resulting premium
is large relative to the amount of protection offered, it is not likely
that anyone will buy insurance, even if on offer. Further, as the
accounting profession formally recognizes in financial accounting
standards, the premium cannot be so large that there is not a
reasonable chance of a significant loss to the insurer. If there is no
such chance of loss, the transaction may have the form of insurance,
but not the substance. (See the U.S. Financial Accounting Standards Board standard number 113)
- Calculable Loss. There are two elements that must be at
least estimable, if not formally calculable: the probability of loss,
and the attendant cost. Probability of loss is generally an empirical
exercise, while cost has more to do with the ability of a reasonable
person in possession of a copy of the insurance policy and a proof of
loss associated with a claim presented under that policy to make a
reasonably definite and objective evaluation of the amount of the loss
recoverable as a result of the claim.
- Limited risk of catastrophically large losses. The essential
risk is often aggregation. If the same event can cause losses to
numerous policyholders of the same insurer, the ability of that insurer
to issue policies becomes constrained, not by factors surrounding the
individual characteristics of a given policyholder, but by the factors
surrounding the sum of all policyholders so exposed. Typically,
insurers prefer to limit their exposure to a loss from a single event
to some small portion of their capital base, on the order of 5 percent.
Where the loss can be aggregated, or an individual policy could produce
exceptionally large claims, the capital constraint will restrict an
insurers appetite for additional policyholders. The classic example is
earthquake insurance, where the ability of an underwriter to issue a
new policy depends on the number and size of the policies that it has
already underwritten. Wind insurance in hurricane zones, particularly
along coast lines, is another example of this phenomenon. In extreme
cases, the aggregation can affect the entire industry, since the
combined capital of insurers and reinsurers can be small compared to
the needs of potential policyholders in areas exposed to aggregation
risk. In commercial fire insurance it is possible to find single
properties whose total exposed value is well in excess of any
individual insurer’s capital constraint. Such properties are generally
shared among several insurers, or are insured by a single insurer who
syndicates the risk into the reinsurance market.
Indemnification
-
The technical definition of "indemnity" means to make whole again.
There are two types of insurance contracts; 1) an "indemnity" policy
and 2) a "pay on behalf" or "on behalf of"[3] policy. The difference is significant on paper, but rarely material in practice.
An "indemnity" policy will never pay claims until the insured has
paid out of pocket to some third party; i.e. a visitor to your home
slips on a floor that you left wet and sues you for $10,000 and wins.
Under an "indemnity" policy the homeowner would have to come up with
the $10,000 to pay for the visitor's fall and then would be
"indemnified" by the insurance carrier for the out of pocket costs (the
$10,000)[4].
Under the same situation, a "pay on behalf" policy, the insurance
carrier would pay the claim and the insured (the homeowner) would not
be out of pocket for anything. Most modern liability insurance is
written on the basis of "pay on behalf" language[5].
An entity seeking to transfer risk (an individual, corporation, or
association of any type, etc.) becomes the 'insured' party once risk is
assumed by an 'insurer', the insuring party, by means of a contract,
called an insurance 'policy'. Generally, an insurance contract
includes, at a minimum, the following elements: the parties (the
insurer, the insured, the beneficiaries), the premium, the period of
coverage, the particular loss event covered, the amount of coverage
(i.e., the amount to be paid to the insured or beneficiary in the event
of a loss), and exclusions (events not covered). An insured is thus
said to be "indemnified" against the loss events covered in the policy.
When insured parties experience a loss for a specified peril, the
coverage entitles the policyholder to make a 'claim' against the
insurer for the covered amount of loss as specified by the policy. The
fee paid by the insured to the insurer for assuming the risk is called
the 'premium'. Insurance premiums from many insureds are used to fund
accounts reserved for later payment of claims—in theory for a
relatively few claimants—and for overhead
costs. So long as an insurer maintains adequate funds set aside for
anticipated losses (i.e., reserves), the remaining margin is an
insurer's profit.
Insurer’s business model
Profit = earned premium + investment income - incurred loss - underwriting expenses.
Insurers make money in two ways: (1) through underwriting,
the process by which insurers select the risks to insure and decide how
much in premiums to charge for accepting those risks and (2) by
investing the premiums they collect from insureds.
The most complicated aspect of the insurance business is the underwriting
of policies. Using a wide assortment of data, insurers predict the
likelihood that a claim will be made against their policies and price
products accordingly. To this end, insurers use actuarial science
to quantify the risks they are willing to assume and the premium they
will charge to assume them. Data is analyzed to fairly accurately
project the rate of future claims based on a given risk. Actuarial
science uses statistics and probability
to analyze the risks associated with the range of perils covered, and
these scientific principles are used to determine an insurer's overall
exposure. Upon termination of a given policy, the amount of premium
collected and the investment gains thereon minus the amount paid out in
claims is the insurer's underwriting profit
on that policy. Of course, from the insurer's perspective, some
policies are winners (i.e., the insurer pays out less in claims and
expenses than it receives in premiums and investment income) and some
are losers (i.e., the insurer pays out more in claims and expenses than
it receives in premiums and investment income).
An insurer's underwriting performance is measured in its combined
ratio. The loss ratio (incurred losses and loss-adjustment expenses
divided by net earned premium) is added to the expense ratio
(underwriting expenses divided by net premium written) to determine the
company's combined ratio. The combined ratio is a reflection of the
company's overall underwriting
profitability. A combined ratio of less than 100 percent indicates
underwriting profitability, while anything over 100 indicates an
underwriting loss.
Insurance companies also earn investment
profits on “float”. “Float” or available reserve is the amount of
money, at hand at any given moment, that an insurer has collected in
insurance premiums but has not been paid out in claims. Insurers start
investing insurance premiums as soon as they are collected and continue
to earn interest on them until claims are paid out.
In the United States, the underwriting loss of property and casualty insurance
companies was $142.3 billion in the five years ending 2003. But overall
profit for the same period was $68.4 billion, as the result of float.
Some insurance industry insiders, most notably Hank Greenberg,
do not believe that it is forever possible to sustain a profit from
float without an underwriting profit as well, but this opinion is not
universally held. Naturally, the “float” method is difficult to carry
out in an economically depressed period. Bear markets do cause insurers
to shift away from investments and to toughen up their underwriting
standards. So a poor economy generally means high insurance premiums.
This tendency to swing between profitable and unprofitable periods over
time is commonly known as the "underwriting" or insurance cycle. [6]
Property and casualty insurers currently make the most money from
their auto insurance line of business. Generally better statistics are
available on auto losses and underwriting on this line of business has
benefited greatly from advances in computing. Additionally, property
losses in the US, due to natural catastrophes, have exacerbated this trend.
Finally, claims and loss handling is the materialized utility of
insurance. In managing the claims-handling function, insurers seek to
balance the elements of customer satisfaction, administrative handling
expenses, and claims overpayment leakages. As part of this balancing
act, fraudulent insurance practices are a major business risk that must be managed and overcome.
History of insurance
-
In some sense we can say that insurance appears simultaneously with
the appearance of human society. We know of two types of economies in
human societies: money economies (with markets, money, financial
instruments and so on) and non-money or natural economies (without
money, markets, financial instruments and so on). The second type is a
more ancient form than the first. In such an economy and community, we
can see insurance in the form of people helping each other. For
example, if a house burns down, the members of the community help build
a new one. Should the same thing happen to one's neighbour, the other
neighbours must help. Otherwise, neighbours will not receive help in
the future. This type of insurance has survived to the present day in
some countries where modern money economy with its financial
instruments is not widespread (for example countries in the territory
of the former Soviet Union).
Turning to insurance in the modern sense (i.e., insurance in a
modern money economy, in which insurance is part of the financial
sphere), early methods of transferring or distributing risk were
practiced by Chinese and Babylonian traders as long ago as the 3rd and 2nd millennia
BC, respectively. Chinese merchants travelling treacherous river rapids
would redistribute their wares across many vessels to limit the loss
due to any single vessel's capsizing. The Babylonians developed a
system which was recorded in the famous Code of Hammurabi, c. 1750 BC, and practiced by early Mediterranean sailing merchants.
If a merchant received a loan to fund his shipment, he would pay the
lender an additional sum in exchange for the lender's guarantee to
cancel the loan should the shipment be stolen.
Achaemenian monarchs were the first to insure their people and made
it official by registering the insuring process in governmental notary
offices. The insurance tradition was performed each year in Norouz
(beginning of the Iranian New Year); the heads of different ethnic
groups as well as others willing to take part, presented gifts to the
monarch. The most important gift was presented during a special
ceremony. When a gift was worth more than 10,000 Derrik (Achaemenian
gold coin) the issue was registered in a special office. This was
advantageous to those who presented such special gifts. For others, the
presents were fairly assessed by the confidants of the court. Then the
assessment was registered in special offices.
The purpose of registering was that whenever the person who
presented the gift registered by the court was in trouble, the monarch
and the court would help him. Jahez, a historian and writer, writes in
one of his books on ancient Iran: "[W]henever the owner of the present
is in trouble or wants to construct a building, set up a feast, have
his children married, etc. the one in charge of this in the court would
check the registration. If the registered amount exceeded 10,000
Derrik, he or she would receive an amount of twice as much."[1]
A thousand years later, the inhabitants of Rhodes invented the concept of the 'general average'.
Merchants whose goods were being shipped together would pay a
proportionally divided premium which would be used to reimburse any
merchant whose goods were jettisoned during storm or sinkage.
The Greeks and Romans
introduced the origins of health and life insurance c. 600 AD when they
organized guilds called "benevolent societies" which cared for the families and paid funeral expenses of members upon death. Guilds in the Middle Ages served a similar purpose. The Talmud deals with several aspects of insuring goods.
Before insurance was established in the late 17th century, "friendly
societies" existed in England, in which people donated amounts of money
to a general sum that could be used for emergencies.
Separate insurance contracts (i.e., insurance policies not bundled with loans or other kinds of contracts) were invented in Genoa
in the 14th century, as were insurance pools backed by pledges of
landed estates. These new insurance contracts allowed insurance to be
separated from investment, a separation of roles that first proved
useful in marine insurance. Insurance became far more sophisticated in
post-Renaissance Europe, and specialized varieties developed.
Toward the end of the seventeenth century, London's growing
importance as a centre for trade increased demand for marine insurance.
In the late 1680s, Mr. Edward Lloyd opened a coffee house that became a
popular haunt of ship owners, merchants, and ships’ captains, and
thereby a reliable source of the latest shipping news. It became the
meeting place for parties wishing to insure cargoes and ships, and
those willing to underwrite such ventures. Today, Lloyd's of London
remains the leading market (note that it is not an insurance company)
for marine and other specialist types of insurance, but it works rather
differently than the more familiar kinds of insurance.
Insurance as we know it today can be traced to the Great Fire of London, which in 1666 devoured 13,200 houses. In the aftermath of this disaster, Nicholas Barbon
opened an office to insure buildings. In 1680, he established England's
first fire insurance company, "The Fire Office," to insure brick and
frame homes.
The first insurance company in the United States underwrote fire insurance and was formed in Charles Town (modern-day Charleston), South Carolina, in 1732. Benjamin Franklin helped to popularize and make standard the practice of insurance, particularly against fire in the form of perpetual insurance. In 1752, he founded the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire.
Franklin's company was the first to make contributions toward fire
prevention. Not only did his company warn against certain fire hazards,
it refused to insure certain buildings where the risk of fire was too
great, such as all wooden houses. In the United States, regulation of the insurance industry is highly Balkanized, with primary responsibility assumed by individual state
insurance departments. Whereas insurance markets have become
centralized nationally and internationally, state insurance
commissioners operate individually, though at times in concert through
a national insurance commissioners' organization. In recent years, some have called for a dual state and federal regulatory system (commonly referred to as the Optional Federal Charter (OFC)) for insurance similar to that which oversees state banks and national banks.
Types of insurance
Any risk that can be quantified can potentially be insured. Specific
kinds of risk that may give rise to claims are known as "perils". An
insurance policy will set out in detail which perils are covered by the
policy and which are not. Below are (non-exhaustive) lists of the many
different types of insurance that exist. A single policy may cover
risks in one or more of the categories set forth below. For example,
auto insurance would typically cover both property risk (covering the
risk of theft or damage to the car) and liability risk (covering legal
claims from causing an accident). A homeowner's
insurance policy in the U.S. typically includes property insurance
covering damage to the home and the owner's belongings, liability
insurance covering certain legal claims against the owner, and even a
small amount of health insurance for medical expenses of guests who are
injured on the owner's property.
Business insurance
can be any kind of insurance that protects businesses against risks.
Some principal subtypes of business insurance are (a) the various kinds
of professional liability insurance, also called professional indemnity insurance,
which are discussed below under that name; and (b) the business owners
policy (BOP), which bundles into one policy many of the kinds of
coverage that a business owner needs, in a way analogous to how
homeowners insurance bundles the coverages that a homeowner needs.[7]
Health
-
Almost all developed countries have government-supplied insurance for health
Health insurance policies will often cover the cost of private medical treatments if the National Health Service in the United Kingdom
(NHS) or other publicly-funded health programs do not pay for them. It
will often result in quicker health care where better facilities are
available. Dental insurance, like medical insurance, is coverage for
individuals to protect them against dental costs. In the U.S., dental
insurance is often part of an employer's benefits package, along with
health insurance. Most countries rely on public funding to ensure that
all citizens have universal access to health care.
Disability
- Disability insurance
policies provide financial support in the event the policyholder is
unable to work because of disabling illness or injury. It provides
monthly support to help pay such obligations as mortgages and credit
cards.
- Total permanent disability insurance
insurance provides benefits when a person is permanently disabled and
can no longer work in their profession, often taken as an adjunct to
life insurance.
- Disability overhead insurance allows business owners to cover the overhead expenses of their business while they are unable to work.
- Workers' compensation insurance replaces all or part of a worker's wages lost and accompanying medical expense incurred because of a job-related injury.
Casualty
-
Casualty insurance insures against accidents, not necessarily tied to any specific property.
- Crime insurance
is a form of casualty insurance that covers the policyholder against
losses arising from the criminal acts of third parties. For example, a
company can obtain crime insurance to cover losses arising from theft
or embezzlement.
- Political risk insurance is a form of casualty insurance that can be taken out by businesses with operations in countries in which there is a risk that revolution or other political conditions will result in a loss.
Life
-
Main article: Life insurance
Life insurance provides a monetary benefit to a decedent's family or
other designated beneficiary, and may specifically provide for income
to an insured person's family, burial, funeral
and other final expenses. Life insurance policies often allow the
option of having the proceeds paid to the beneficiary either in a lump
sum cash payment or an annuity.
Annuities
provide a stream of payments and are generally classified as insurance
because they are issued by insurance companies and regulated as
insurance and require the same kinds of actuarial and investment
management expertise that life insurance requires. Annuities and pensions that pay a benefit for life are sometimes regarded as insurance against the possibility that a retiree
will outlive his or her financial resources. In that sense, they are
the complement of life insurance and, from an underwriting perspective,
are the mirror image of life insurance.
Certain life insurance contracts accumulate cash
values, which may be taken by the insured if the policy is surrendered
or which may be borrowed against. Some policies, such as annuities and endowment policies, are financial instruments to accumulate or liquidate wealth when it is needed.
In many countries, such as the U.S. and the UK, the tax law
provides that the interest on this cash value is not taxable under
certain circumstances. This leads to widespread use of life insurance
as a tax-efficient method of saving as well as protection in the event of early death.
In U.S., the tax on interest income on life insurance policies and
annuities is generally deferred. However, in some cases the benefit
derived from tax deferral may be offset by a low return. This depends
upon the insuring company, the type of policy and other variables
(mortality, market return, etc.). Moreover, other income tax saving
vehicles (e.g., IRAs, 401(k) plans, Roth IRAs) may be better
alternatives for value accumulation. A combination of low-cost term
life insurance and a higher-return tax-efficient retirement account may
achieve better investment return.
Property
-
Property insurance provides protection against risks to property, such as fire, theft or weather damage. This includes specialized forms of insurance such as fire insurance, flood insurance, earthquake insurance, home insurance, inland marine insurance or boiler insurance.
- Automobile insurance, known in the UK as motor insurance, is probably the most common form of insurance and may cover both legal liability claims against the driver and loss of or damage to the insured's vehicle itself. Throughout the United States
auto insurance policy is required to legally operate a motor vehicle on
public roads. In some jurisdictions, bodily injury compensation for
automobile accident victims has been changed to a no-fault
system, which reduces or eliminates the ability to sue for compensation
but provides automatic eligibility for benefits. Credit card companies
insure against damage on rented cars.
- Driving School Insurance
insurance provides cover for any authorized driver whilst under going
tuition, cover also unlike other motor policies provides cover for
instructor liability where both the pupil and driving instructor are
both equally liable in the event of a claim.
Classical
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