Insurance

Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of potential financial loss. Insurance is defined as the equitable transfer of the risk of a potential loss, from one entity to another, in exchange for a reasonable fee and duty of care.

Principles of Insurance

The timing or occurrence of the loss must be uncertain.

The rate of losses must be relatively predictable: In order to set premiums (prices) insurers must be able to estimate them. If the coverage is unique, the insured will pay a correlatingly higher premium. Lloyd's of London often accepts unique coverages. (e.g. the insuring of Tina Turner's legs)

The losses must be predictable on a macro level: Insurers need to know how much it would be required to pay when the insured event occurs. Most types of insurance have maximum levels of payouts, but not all do, notably health insurance.

The loss must be significant: The legal principle of De minimis dictates that trivial matters are not covered. Furthermore, rational insurance uses existing insurance when the transaction costs dictate that filing a claim is not rational.

The loss must not be catastrophic: If the insurer is insolvent, it will be unable to pay the insured. Note that, in the United States, there exists a little-known system of Guaranty Funds to reimburse insured people whose insurance companies have become insolvent. [1] This program is run by the National Association of Insurance Commissioners (NAIC). [2]

Indemnification

An entity seeking to transfer risk (an individual, corporation, or association of any type) becomes the 'insured' party once risk is assumed by an 'insurer', the insuring party, by means of a contract, defined as an insurance 'policy'. This legal contract sets out terms and conditions specifying the amount of coverage (compensation) to be rendered to the insured, by the insurer upon assumption of risk, in the event of a loss, and all the specific perils covered against (indemnified), for the term of the contract.

When insured parties experience a loss, for a specified peril, the coverage entitles the policyholder to make a 'claim' against the insurer for the amount of loss as specified by the policy contract. The fee paid by the insured to the insurer for assuming the risk is called the 'premium'. Insurance premiums from many clients are used to fund accounts set aside 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, the remaining margin becomes their profit.

Example: home insurance

For example, let us assume a home is purchased for $100,000. Knowing the loss of the home from a peril would cause significant financial loss, insurance coverage is ordinarily acquired in the form of a homeowner's policy. The insurance company charges the insured a premium, of perhaps $1,000 a year in this example, for assuming liability for the risk. At this point, the risk of loss has been transferred from the insured to the insurance company. In the event of a covered peril, the insurer pays the claimant the amount of loss according to the terms of the contract, in ordinary circumstances, which may amount to the cost of replacing or repairing the home.

How an insurance company makes money

A customer may pay one or more premium payments over time. The company collects these payments from one or more customers. If something happens which triggers a claim, the company then pays out a certain amount of money. If, during the lifetime of all of the company's insurance contracts, it pays out less than it has taken in, it makes what is known as an underwriting profit. One measure of an insurance company's performance is their loss ratio (incurred losses and loss-adjustment expenses divided by net earned premium). The loss ratio is added to the expense ratio (underwriting expenses divided 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 a profit, while anything over 100 is a loss. Two companies that are famous for achieving underwriter profit are American International Group and Berkshire Hathaway.

In many cases a company's combined ratio is greater than 100 percent, however the company still manages to make money. This is because in between the time the company collects premiums and when it pays out claims, it can invest that money. The return from these investments can offset an underwriting loss resulting in profit. For example, if a company has to pay out 10 percent more than it took in, but made a 20 percent return on its investment, then it made a 10 percent profit. However, since most insurance companies consider it only prudent to invest in risk-free government bonds, or other lower risk and lower return forms of investments, it's important that the extra amount it has to pay out compared to what it has to take in is less than the percent return of these investments. If it isn't, the company loses money. The extra amount that a company has to pay out can be considered a "cost of funds" and be compared to an interest rate of the same company borrowing money. Because of this, most insurance companies don't have a goal just to have any amount of profit over the cost of funds, but rather to have this cost of funds to be lower than what they would have been able to get by borrowing somewhere else. If this isn't the case, the insurance company does not add any value to their owners, who theoretically could have borrowed money from somewhere else and made the same investments themselves.

Determination of rate structures

The insurer uses actuarial science to quantify the risk they are willing to assume. Data is generated to approximate future claims, ordinarily with reasonable accuracy. Actuarial science uses statistics and probability to analyze the risks associated with the range of perils covered, and these scientific principles are used by insurers, in conjunction with additional factors, to determine rate structures.

For example, many individuals purchase homeowner's insurance policies by signing a contract paying a premium to an insurance company. If a covered loss occurs, the insurer is obliged by the terms of the contract to honor the insured's claim. For some policyholders, the amount of insurance benefits received from their insurer will greatly exceed the expense of premiums paid. Others may never make a claim or receive any benefit other than the peace of mind rendered by the security of an insurance policy. When averaged, the total claims expense paid by an insurer should be less than the total premiums paid by their policyholders, with the difference allocated to overhead and profit.

Insurance companies also earn investment profits. These are generated by investing premiums received until they are needed to pay claims. This money is called the 'float'. The insurer may make profits or losses from the value change in the float as well as interest or dividend on the float. 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, at 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.

Gambling analogy

Some people erroneously consider insurance a type of wager (particularly as associated with moral hazard) that executes over the policy period. The insurance company bets that you or your property will not suffer a loss while you put money on the opposite outcome. The difference in the fees paid to the insurance company versus the amount for which they can be held liable if an accident happens is roughly analogous to the odds one might expect when betting on a racehorse (for example, 10 to 1). For this reason, a number of religious groups including the Amish and Muslims avoid insurance and instead depend on support provided by their communities when disasters strike. This can be thought of as "social insurance", as the risk of any given person is assumed collectively by the community who will all bear the cost of rebuilding. In closed, supportive communities where others will actually step in to rebuild lost property, this arrangement can work. Most societies could not effectively support this type of system and the system will not work for large risks. For very large risks, Western insurance can also run into difficulties. This is the reason why most homeowner's insurance does not cover floods. A company that sells homeowner's insurance in a given city can fairly accurately estimate how many fires, tornadoes, and so forth it can expect to pay out. However, a flood may impact a large percentage of the city and the company might be unable to deal with this.

However, since in gaming or gambling the game is supposed to be fixed at the start so that the odds are not supposed to be affected by no-game elements by the players. In fire insurance on the other hand, insurers require that policyholders do risk mitigation like installing sprinklers thereby reducing the odds of loss. In addition, after a loss, say disability, insurers specialize in providing rehabilitation to reduce the loss after it occurs. It is only when the odds of the bad outcome nor the severity of loss can be mitigated that insurance is not true insurance. That is when the existence of the fire policy entices a criminal into arson insurance is not truly insuring anything.

The gambling analogy holds with insurance in terms of risk and reward. The difference is in the motivation behind the process. When gambling, you are assuming risk that you would not otherwise be exposed to that has the possibility of either a loss or a gain (speculative risk). With insurance, you are managing risk that you could not otherwise avoid, and which does not present the possibility of gain (pure risk). In other words, gambling is not an insurable risk.

History of insurance

Early methods of transferring or distributing risk were practiced by Babylonian traders as long ago as the 2nd millennium BCE. 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.

A thousand years later, the inhabitants of Rhodes invented the concept of the 'general average'. Merchants whose goods were being shipped together would pay 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 acted to care for the families and funeral expenses of members upon death. Guilds in the Middle Ages served a similar purpose. The Talmud deals with several aspects of insuring goods.

Insurance became far more sophisticated in post-Renaissance Europe, and specialized varieties developed.

Toward the end of the seventeenth century, the growing importance of London as a centre for trade led to rising demand for marine insurance. In the late 1680s, Mr Edward Lloyd opened a coffee house which 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, Lloyds of London remains the leading market for marine and other specialist types of insurance, but it works rather differently to the more familiar kinds of insurance. (See Lloyd's of London).

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 provided 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 commissioner's organization. In recent years, some have called for a federal regulatory system for insurance similar to that of the banking industry.

In the State of New York, which has unique laws in keeping with its stature as a global business center, attorney general Eliot Spitzer has been in a unique position to grapple with major national insurance brokerages. Spitzer alleged that Marsh & McLennan steered business to insurance carriers based on the amount of contingent commissions that could be extracted from carriers, rather than basing decisions on whether carriers had the best deals for clients. Several of the largest commercial insurance brokerages have since stopped accepting contingent commissions and have adopted new business models.

Types of insurance

Any risk that can be quantified probably has a type of insurance to protect it. Among the different types of insurance are:

Automobile insurance, also known as auto insurance, car insurance and 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 vehicle itself. Over most of the United States purchasing an auto insurance policy is required to legally operate a motor vehicle on public roads. Recommendations for which policy limits should be used are specified in a number of books.
Casualty insurance insures against accidents, not necessarily tied to any specific property.
Credit insurance pays some or all of a loan back when certain things happen to the borrower such as unemployment, disability, or death.
Financial loss insurance protects individuals and companies against various financial risks. For example, a business might purchase cover to protect it from loss of sales if a fire in a factory prevented it from carrying out its business for a time. Insurance might also cover failure of a creditor to pay money it owes to the insured. Fidelity bonds and surety bonds are included in this category.
Health insurance covers medical bills incurred because of sickness or accidents.
Liability insurance covers legal claims against the insured. For example, a homeowner's insurance policy provides the insured with protection in the event of a claim brought by someone who slips and falls on the property, and brings a lawsuit for her injuries. Similarly, a doctor may purchase liability insurance to cover any legal claims against him if his negligence (carelessness) in treating a patient caused the patient injury and/or monetary harm. The protection offered by a liability insurance policy is two-fold: a legal defense in the event of a lawsuit commenced against the policyholder, plus indemnification (payment on behalf of the insured) with respect to a settlement or court verdict.
Life insurance provides a cash benefit to a decedent's family or other designated beneficiary, and may specifically provide for burial and other final expenses.
- Annuities provide a stream of payments and are generally classified as insurance because they are issued by insurance companies and regulated as insurance. 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.
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.
Locked Funds Insurance is a little known hybrid insurance policy jointly issued by governments and banks. It is used to protect public funds from tamper by unauthorised parties. In special cases, a government may authorise its use in protecting semi-private funds which are liable to tamper. Terms of this type of insurance are usually very strict. As such it is only used in extreme cases where maximum security of funds is required.
Marine Insurance covers the loss or damage of goods at sea. Marine insurance typically compensates the owner of merchandise for losses sustained from fire, shipwreck, etc., but excludes losses that can be recovered from the carrier.
Nuclear incident insurance - damages resulting from an incident involving radioactivive materials is generally arranged at the national level. (For the United States, see Price-Anderson Nuclear Industries Indemnity Act.)
Political risk insurance 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.
Professional Indemnity Insurance is normally a mandatory requirement for professional practitioners such as Architects, Lawyers, Doctors and Accountants to provide insurance cover against potential negligence claims. Non licensed professionals may also purchase malpractice insurance, it is commonly called Errors and Omissions Insurance and covers a service provider for claims made against them that arise out of the performance of specified professional services. For instance, a web site designer can obtain E&O insurance to cover them for certain claims made by third parties that arise out of negligent performance of web site development services.
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 or boiler insurance.
Terrorism insurance
Title insurance provides a guarantee that title to real property is vested in the purchaser and/or mortgagee, free and clear of liens or encumbrances. It is usually issued in conjunction with a search of the public records done at the time of a real estate transaction.
Travel insurance is an insurance cover taken by those who travel abroad, which covers certain losses such as medical expenses and theft.
Workers' compensation insurance replaces all or part of a worker's wages lost and accompanying medical expense incurred due to a job-related injury.

A single policy may cover risks in one or more of the above categories. For example, car insurance would typically cover both property risk (covering the risk of theft or damage to the car) and liability risk (covering legal claims from say, causing an accident). A homeowner's insurance policy in the US 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.

Potential sources of risk that may give rise to claims are known as "perils". Examples of perils might be fire, theft, earthquake, hurricane and many other potential risks. An insurance policy will set out in details which perils are covered by the policy and which are not.

Types of insurance companies

Insurance companies may be classified as

Life insurance companies, who sell life insurance, annuities and pensions products.
Non-life or general insurance companies, who sell other types of insurance.

In most countries, life and non-life insurers are subject to different regulations, tax and accounting rules. The main reason for the distinction between the two types of company is that life business is very long term in nature — coverage for life assurance or a pension can cover risks over many decades. By contrast, non-life insurance cover usually covers a shorter period, such as one year.

Insurance companies are generally classified as either mutual or stock companies. This is more of a traditional distinction as true mutual companies are becoming rare. Mutual companies are owned by the policyholders, while stockholders, (who may or may not own policies) own stock insurance companies.

Reinsurance companies are insurance companies that sell policies to other insurance companies, allowing them to reduce their risks and protect themselves from very large losses. The reinsurance market is dominated by a few very large companies, with huge reserves.

Captive Insurance companies may be defined as limited purpose insurance companies established with the specific objective of financing risks emanating from their parent group or groups. This definition can sometimes be extended to include some of the risks of the parent company's customers. In short terms, it is an in-house self-insurance vehicle. Captives may take the form of a "pure" entity (which is a 100% a subsidiary of the self-insured parent company); of a "mutual" captive (which insures the collective risks of industry members) and of an "association" captive (which self-insures individual risks of the members of a professional, commercial or industrial association). Captives represent commercial, economic and tax advantages to their sponsors due to the reductions on costs they help create, the ease for insurance risk management and the flexibility for cash flows they generate. Additionally, they may provide coverage of risks which are neither available nor offered in the traditional insurance market at reasonable prices.

The types of risk that a captive can underwrite for the parent include property damage, public and products liability, professional indemnity, employee benefits, employers liability, motor and medical aid expenses. The captive's exposure to such risks may be limited by the use of reinsurance.

Captives are becoming an increasingly important component of the risk management and risk financing strategy of their parent. This can be understood against the following background:

heavy and increasing premium costs in almost every line of coverage;
difficulties in insuring certain types of fortuitous risk;
differential coverage standards in various parts of the world;
rating structures which reflect market trends rather than individual loss experience;
insufficient credit for deductibles and/or loss control efforts.

There are also companies known as 'insurance consultants'. Like a mortgage broker, these companies are paid a fee by the customer to shop around for the best insurance policy amongst many companies .

Similar to an insurance consultant, an 'insurance broker' also shops around for the best insurance policy amongst many companies. However, with insurance brokers, the fee is usually paid in the form of commission from the insurer that is selected rather than directly from the client.

Third Party Administrators are companies that perform underwriting and sometimes claims handling services for insurance companies. These companies often have special expertise that the insurance companies do not have.

Life insurance and saving

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. See life insurance.

In many countries, such as the US and the UK, 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.

Financial viability of insurance companies

Financial stability and strength of the insurance company should be a major consideration when purchasing an insurance contract. An insurance premium paid currently provides coverage for losses that might arise many years in the future. For that reason, the viability of the insurance carrier is very important. In recent years, a number of insurance companies have become insolvent, leaving their policyholders with no coverage (or coverage only from a government-backed insurance pool with less attractive payouts for losses). A number of independent rating agencies, such as Best's, provide information and rate the financial viability of insurance companies.

Controversies

Insurance insulates too much

By creating a "security blanket" for its insureds, an insurance company may inadvertently find that its insureds may not be as risk-averse as they should be (since the insured assumes the risk belongs to the insurer). This problem is known to the insurance industry as moral hazard. To reduce their own financial exposure, insurance companies have contractual clauses that mitigate their obligation to provide coverage if the insured engages in some kind of behavior that grossly magnifies their risk of loss or liability.

For example, liability insurance providers do not provide coverage for liability arising from intentional torts committed by the insured. Even if a provider was irrational enough to try to provide such coverage, it is against the public policy of most countries to allow such insurance to exist, and thus it is usually illegal.

Complexity of insurance policy contracts

Insurance policies can be complex and some policyholders may not understand all the fees, regulation and coverages included in a policy. As a result, people could buy policies at unfavorable terms. In response to these issues, governments often make detailed regulations that set down minimum standards for policies and govern how they may be advertised and sold.

Many individuals purchase policies through an insurance broker. The broker can counsel the policyholder on which coverage to purchase and limitations of the policy. A broker generally holds contracts with many insurers which allows the broker to "shop" the market for the best rates and coverage possible.

Redlining

Redlining is the practice of some insurance companies to deny the issuance of coverage in specific geographic areas, usually due to an increased likelihood of risk; the validity of the assessment may be real or perceived, though it is often attributed to discrimination.

Evaluation of risk, when an insurer determines a premium or premium rate structure, considers quantifiable factors, including location, credit scores, gender, occupation, marital status, and education level. However, the use of these essential factors, whether inappropriately or not, are often considered to be 'unfair' or discriminatory by some consumers and their advocates, sometimes leading to political disputes about insurers' determination of premiums and possible government intervention to limit the factors used.

A refutation to this is that the job of an insurance underwriter is to properly categorize a given risk as to the likelihood that the loss will occur. Any factor that causes a greater likelihood of loss should in theory, be charged a higher rate. This is a basic principle of insurance and must be followed for insurance companies or groups to operate properly, even for non-profit organizations. Thus, discrimination of potential insureds by legitimate factors is central to insurance. Therefore the only thing that can be considered legitimately "unfair" are practices that discriminate against a given group without actual factors that show that the group is a higher risk. So, eliminating real factors discriminates against other insureds by forcing them to bear part of the cost of the disallowed perceived factors.

Health insurance

Health insurance, which is coverage for individuals to protect them against medical costs, is a highly charged and political issue in the United States, which does not have socialized health coverage. In theory, the market for health insurance provision should function in a manner similar to other insurance coverages, but the skyrocketing cost of health coverage has disrupted markets around the globe, but perhaps most glaringly in the US. Please see health insurance for a discussion of this category.

Dental insurance

Dental insurance, like health insurance, is coverage for individuals to protect them against dental costs. Dental insurance usually goes hand-in-hand with health insurance, with most people in the United States receiving it included in their health insurance plan from their employer. Along with receiving dental insurance from your employer, their are ways to receive dental insurance through resellers and companies for individuals and families; although this way tends to be too expensive for most people.

Insurance Patents

New insurance products can now be protected from copying with a business method patent. This may lead to the more rapid introduction of new insurance products as insurance companies will invest more heavily in new product development if they can be reasonably assured that their patents will keep those products from being copied.

A recent example of a new insurance product that is patented is telematic auto insurance. It was independently invented and patented by a major US auto insurance company, Progressive Auto Insurance (US patent 5,797,134) and a Spanish independent inventor, Salvador Minguijon Perez (European Patent EP0700009B1).

The basic idea of telematic auto insurance is that a driver's behavior is monitored directly while the person drives and this information is transmitted to an insurance company. The insurance company then assesses the risk of that driver having an accident and charges insurance premiums accordingly. A driver that drives a lot of distance at high speed, for example, will be charged a higher rate than a driver that drives small distances at low speed.

A British auto insurance company, Norwich Union, has taken a license to both the Progressive patent and Perez patent. They have made additional investments in infrastructure to developed a commercial offering called "Pay As You Drive" or PAYD.

Many independent inventors are in favor of patenting new insurance products since it gives them protection from big companies when they bring their new insurance products to market. Independent inventors account for 70% of the new US patent applications in this area.

Many insurance executives are opposed to patenting insurance products because it creates a new risk for them. [The Hartford] insurance company, for example, had to recently pay US$80 million to an independent inventor, Bancorp Services, in order to settle a patent infringement and theft of trade secret lawsuit for a new type of corporate owned life insurance product invented and patented by Bancorp.

The Insurance Industry and Rent Seeking

Certain insurance products and practices have been described as rent seeking by critics. That is, insurance companies have been alleged to have certain products or practices that are only useful due to certain government laws (especially tax laws), and that the insurance industry in these cases generally adds no economic value but instead supports politicians who will continue the legal regime which gives the insurance company these benefits. For example, in the United States the current tax rules generally allow owners of variable annuities and variable life insurance to invest in the stock market and defer paying any taxes until withdrawals are made. Often this tax avoidance is the only benefit gained from purchasing these products instead of a mutual fund. Another example is the legal infrastructure which allows life insurance to be held in an irrevocable trust which is used to pay an estate tax while the proceeds itself are immune from the estate tax.

Glossary

'Combined Ratio' = loss ratio + expense ratio. Loss Ratio is calculated by dividing the amount of losses by the amount of written premium. Expense ratio is calculated by dividing the amount of operational expenses by the amount of earned premium. A lower number indicates a better return on the amount of capital placed at risk by an insurer.

Quote

Hank Greenberg told his board of directors, "you can't even spell 'insurance'"[3] ((hearsay, April 2005)

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