Insurance
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Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of potential financial loss. Ideally, 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. In practice, however, the business of providing insurance protection often ends up in litigation between the parties involved, while the responsibilities of regulating insurance markets routinely winds up as a political football for government agencies.
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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 magin 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.
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 conjuction 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 obligated 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.
Gambling analogy
Some people 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 avoid insurance and instead depend on support provided by their communities when disasters strike. 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.
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 Rhodesians 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.
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 1752, he founded the Philadelphia Contributorship 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 the State of New York, which has unique laws in keeping with its stature as a global business center, attorney general Elliott Spitzer has been in a unique position to grapple with major national insurance brokerages. Spitzer found 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.
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.
- 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 doctor may purchase insurance to cover any legal claims against him if he were to be convicted of a mistake in treating a patient.
- Life insurance provides a benefit to a decedent's family or other designated beneficiary, to replace loss of the insured's income and 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.
- 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.
- 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.
- 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.
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.
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). 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 discrimation.
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 racist 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.
ranging from rising expenses for insurers due to the spread of insurance fraud schemes on the one hand, to charges from consumers of discriminatory rate structures and unfair claims handling practices on the other.
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.
Glossary
- 'Combined ratio' (calculated by dividing the sum of incurred losses and expenses by earned premium) = (incurred losses + incurred underwriting expenses) ÷ earned premiums; (or) = loss ratio + expense ratio + dividend ratio. 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'"[1] (http://editor.slate.msn.com/default.aspx/id/2116167/nav/ais/) ((hearsay, April 2005)
See also
- Cindy Ossias
- False insurance claims
- Financial services (broader industry to which insurance belongs)
Lists
External links
- Insurance industry statistics in the U.S. [2] (http://www.iii.org/media/facts/statsbyissue/industry/)
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