Insurance

Principles of insurance

Insurable risks share seven characteristics:

Lots of entities have a similar need. The vast majority of insurance policies are provided for members of large groups. For example about 100 million people in the United States pay for car Insurance. With large groups the cost of insuring a lot of people becomes fairly consistent from month to month. As with any rule there are exceptions.  For example Lloyd's of London is famous for insuring the life or health of actors, actresses and sports figures.

Clearly defined Loss. The risk that is being insured against needs to be very clearly specified for it to be insurable.  For instance death is a clearly defined loss and can be insured against through life insurance. 

Accidental Loss. The event that leads to a claim should not be intentionally caused, or easily prevented by the insured.  Home insurance often guards against natural disasters such as storm, fire and flood that people cannot easily guard against.  There are exeptions to this characteristic in some car insurance because damage caused by a driver may still be covered depending on the plan, but for the often there insurances buyers are expected to display a reasonable degree of discretion in any accident in order to receive to be compensated by their insurance policies.

Large Loss. The size of the loss will disrupt the normal finances of the insured. Insurance companies need to pay for administrative costs like sales and marketing, fraud protection and the cost of implementing payouts. These costs make it unreasonable for people to insure against small losses like a flat tire or a the time lost watching a bad movie.

Affordable Premium. Nobody will buy insurance plans if a premium is large relative to the amount of protection offered.

Calculable Loss. Insurance companies must be able to estimate the probability of a loss and how much the loss will cost to provide insurance against it at a reasonable premium.

Limited risk of catastrophically large losses. If one event can cause losses to many policyholders, the ability of that insurer to issue policies becomes constrained.  Insurers limit their exposure to a loss from a single event to a small portion of their working capital by carefully selecting which policies they want to sell and by buying reinsurance. A common example in our post-Katrina world is Hurricane insurance, where the ability of an create to issue a new policy depends on the number and size of the policies that it has already agreed to.

Indemnification

In layman’s terms "indemnity" means to make whole again. In legal circles it can be understood as the need to compensate another party for any loss suffered during the performance of a contract.

The contracts used to set up insurance arrangements are usually called policies. These policies usually include the following elements: the premium, the parties, the period of coverage, the amount of coverage, the particular loss event covered, and exclusions.

When an entity suffers a loss they are insured for, the coverage entitles the policyholder to make a 'claim' against the insurer for the covered amount of loss. 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.

Insurers' business model

Underwriting and investing

The business model of all insurance providers can be reduced to a simple equation: Profit = premium + investment income - loss - administrative expenses.

Here we can see that insurers make money in two ways: by selling insurance policies and investing the premiums they collect.  Most insurance companies focus their resources on developing their competency in selling insurance rather than making investments. Using lots of data and actuarial science, insurers predict the probability a claim will be made against their policies and price policies accordingly.  Actuarial science uses statistics and probability to analyze the risks associated with the losses covered, and these scientific principles are used to determine an insurer's exposure. From the insurer's perspective, some policies are winners (i.e., the insurer pays out less in claims and expenses than it collects in premiums and investment income) and some are losers.  In the same vein insurance buyers determine the value received from their insurance purchases by looking at how much it cost them and what benefits they received.

Claims

Claims are the actual service paid for, though most insurance buyers hope it never has to be used.  Claims can be filed directly with the insurer or through brokers or agents.

Claim departments employ a lot of claims adjusters supported by records managers and data entry clerks. Incoming claims are classified based on severity and type and get assigned to adjusters who decide on appropriate compensation. The adjuster performs a thorough investigation of each claim with the participation of the insured, calculates a reasonable monetary value, and authorizes payment. Liability insurance claims is one of the most difficult types of claims to adjust because there is a third party involved (the plaintiff who is suing the insured) and they often do not cooperate with adjusters. The adjuster must obtain legal counsel for the insured, monitor litigation that may take years to complete, and appear in person or via telephone at legal proceedings.

In managing the claims handling, insurers seek to balance customer satisfaction, administrative expenses, and overpayment leakages. As part of this balancing act, fraudulent insurance practices are a major business risk that must be managed and overcome. Disputes over the validity of claims or appropriate payouts occasionally escalate into litigation.

History of insurance

The Greeks and Romans introduced health and life insurance at about 600 AD when they organized groups called "benevolent societies" which cared for the families and paid funeral expenses of members upon death.  The funds for these benefits were provided through taxation so at that time insurance was a government sponsored public good.  Insurance contracts were invented in Genoa in the 14th century. These new contracts allowed insurance to be separated from investment. Insurance became much more sophisticated in post-Renaissance Europe, when specialized varieties developed.

The creation of the insurance industry as we know it can be traced to 1666 when the Great Fire of London devoured 13,200 houses.  Shortly after this disaster, Nicholas Barbon created a company to insure buildings. In 1680, he created England's first fire insurance company which he named The Fire Office.

The first insurance company in the United States and was formed in Charleston, South Carolina, in 1732 and sold fire insurance. In the United States, regulation of the insurance is typically assumed by individual states. In the past decade, some people have lobbied for a dual state and federal regulatory system for insurance similar to that which oversees banking.

Types of insurance

Any risk of loss that can be quantified can be insured. The types of risk that may result in claims are known as "perils". Good insurances policies very specifically state which perils are covered by the policy and which are not. Below is a list of the some common types of insurance. A single policy may cover risks in several of these categories. For example, auto insurance usually covers both property risk (theft or damage to the car) and liability risk (legal claims from causing an accident).

Auto insurance

Auto insurance protects against financial lost resulting from an accident.  Premiums are paid to an insurance company which agrees to pay for losses defined in the policy. Auto insurance provides medical, liability and property coverage.  Property coverage pays for damage to or theft, Liability for your legal responsibility to others for bodily injury or property damage and Medical for the cost of treating injuries, rehabilitation and sometimes lost wages and funeral expenses.  Most auto policies exist for six to twelve months. Insurance companies contact customers when it’s time to renew the policy or pay the premium.

Home insurance

Home insurance provides compensation for damage to a home suffered by natural disasters. In some areas this insurance excludes certain types of disasters, such as flood and earthquakes, but they can be guarded against by purchasing additional coverage. Maintenance-related problems not typically covered by home insurance. Some insurers offer policies that cover liability and for injuries and property damage caused by members of the household, including pets.

Health

Most advanced countries have government-supplied insurance for personal health. Dental insurance is a subset of health insurance and is protects buyers against dental costs. In the U.S., medical and dental insurance is often part of an employer's benefits. Most countries rely on some sort of public funding to make sure all citizens have access to health care.

Disability

Disability insurance policies provide financial support when policyholders are unable to work due to illness or injury. It provides monthly income to allow recipients to continue their lives. Total permanent disability insurance provides benefits when a person is permanently disabled and can no longer work in their current occupation and has many similarities to life insurance. Workers' compensation insurance replaces lost wages and medical expenses incurred because of a job-related injury.

Life

Life insurance provides a monetary benefit to a beneficiary and covers, burial, funeral and other death expenses.  Often it provides the option of having the proceeds paid in a lump sum payment or an annuity.

Annuities provide consistent payments over a long period of time and are often classified as insurance because they are usually issued by insurance companies and regulated as insurance.  Annuities and pensions that pay a benefit for life are often considered insurance against the possibility that a retiree will outlive their financial resources.  Some life insurance contracts build value, which may be paid out to the insured if the policy is surrendered or can be used as collateral for taking out loans.

Property

Property insurance guarantees protection against risks to property damage. This includes specialized forms of insurance such as fire insurance, earthquake insurance, flood insurance, inland marine insurance, home insurance, or boiler insurance.  Boiler insurance protects against losses resulting from accidental damage to equipment or machinery. Builder's risk insurance protects against the risk of loss or damage to property during construction. Builder's risk insurance is often written on an "all risk" basis covering damage due to any cause that is not explicitly excluded.

Farmers use crop insurance to manage risks associated with growing crops. These risks include crop loss or damage caused by weather, drought, hail, frost, insects, damage, or disease.

Earthquake insurance is a type of property insurance that covers losses to policyholders in the event of an earthquake that damages covered property. This is regarded as its own kind of insurance because most homeowners’ insurance policies do not cover earthquake damage. Most earthquake insurance policies feature a high deductible and rates vary by location as well as the construction of the home.

Flood insurance protects against property loss due to flooding. Most insurers do not provide flood insurance in some portions of the country because the risk of flooding is too high. In response to this, the federal government has started the National Flood Insurance Program which serves as the insurer of last resort.

Liability

Liability insurance covers legal claims against the insured. Many types of insurance include some form of liability coverage. For example, a homeowner's insurance policy often includes liability coverage to protect the insured in the event of a claim brought by someone who slips and falls on the property. Liability insurance offers two benefits: legal defense of a lawsuit against the policyholder and indemnification of a settlement or court verdict. Liability policies often cover only negligence of the insured, and do not apply to willful or intentional acts.

Environmental liability insurance guards the insured from bodily injury, property damage and cleanup costs as a result of the pollution.

Professional liability insurance, protects professionals such surgeons against potential negligence claims made by patients or clients. This insurance may take on different names depending on the profession. For example, professional liability is often called malpractice insurance in medical fields.

Credit

Credit insurance repays part or all of a loan when certain things happen to the borrower experience great challenges that impair their ability to pay off debt.

Mortgage insurance insures the lender against default by borrowers. This is a form of credit insurance, however, the phrase credit insurance is usually used to refer to policies that cover other kinds of debt.

Other types

Defense Base Act Workers' compensation provides coverage for civilian workers employed by the government on engagements outside the U.S. and Canada. DBA is required expense for all American citizens, U.S. residents, U.S. Green Card holders, and all employees or subcontractors hired on overseas government contracts. This usually covers expenses related to medical treatment and disability, as well as death benefits.

Financial loss insurance protects entities against financial risks. For example, a business might purchase a policy that protects it from loss of sales if a fire in a factory prevented it from carrying out its business functions. Insurance might also cover the inability of a creditor to pay money it owes. This kind of insurance is often referred to as business interruption insurance.

Purchase insurance was created to protect the products people purchase. These agreements are often referred to as warranties, care plans, or guarantees. Such insurance usually covers a very limited set of risks.

Travel insurance can be purchase by people traveling to foreign counties to cover medical expenses, personal liabilities, loss of personal belongings, travel delay, etc.

Insurance financing vehicles

Protected Self-Insurance is a risk financing system where an organization retains the calculated average cost of risk and transfers the catastrophic risk (with limits) to an insurer. A properly designed Protected Self-Insurance Program stabilizes cash flows, reduces the cost of insurance and provides valuable risk management information.

Self insurance is the decision to pay for otherwise insurable losses out of one's own pocket. This can be done on a formally by creating a separate fund where payments are periodically deposited, or by simply not buying insurance. Self insurance works well for high-frequency, low-severity losses. These losses, if covered by conventional insurance, would require clients to pay a premium that includes supports a company's general expenses, premium taxes, cost of putting the policy on the books, and contingencies. While this is the case for all insurance, small, common losses cause the transaction costs to exceed the value of the stability insurance provides.

No-fault insurance refers to a policy where insurance buyers are indemnified by their insurer regardless of fault in the incident.

Reinsurance is a kind of insurance bought by insurance companies or to protect against unexpected losses. Financial reinsurance is a type of reinsurance that is purchasd for capital management rather than the transfer of risk.

Social insurance can refer to different things in different cultures. Generally it is a collection of coverages (including health insurance, life insurance, unemployment insurance, disability income insurance, etc.), in addition to retirement savings, that requires participation of all the citizens of a country. By making participation manditory everyone can become a claimant when they need to.

Insurance companies

Insurance companies can be classified in two groups: Life insurance companies (which provide life insurance, pension and annuities products) plus non-life companies, which sell other kinds of insurance.

Life and non-life insurers are subject to different regulations, tax and accounting rules in most countries. The main reason for the distinction is that the life insurance business is very long-term in nature. Non-life insurance cover covers a shorter period.

In America, most standard insurers use pattern or cookie-cutter policies without variation from one person to the next. They usually have lower premiums than highly specialized insurers and can sell directly to individuals. They are strictly regulated by state.

Excess line insurance companies usually insure risks not covered by the standard lines. These companies have more flexibility and can change faster than standard insurance companies because they are not required meet the same regulations as standard line issuers. Despite this they still have substantial regulatory requirements placed upon them by state governments.

Insurance companies are sometimes divided up as either mutual or stock companies. Mutual companies are owned by the policyholders, while stock holders own stock insurance companies. Demutualization of mutual insurers to form stock companies became common in many western countries in the last 30 years. Other possible forms for an insurance company include reciprocals, in which policyholders share risks.

Insurance companies are regularly rated by agencies such as A. M. Best. These ratings examine a company's financial strength, which is a direct measure of its ability to pay claims. The agencies also rates financial instruments issued by these businesses.

Reinsurance companies are insurance companies that sell coverage to other insurance companies, which them to better manage risks associated with events causing large losses. The reinsurance market is composed of a few very large companies that have large reserves.

In this field there are also insurance consultants that are paid a fee to shop around for the best insurance policy amongst many providers. Consultants are similar to brokers but, with insurance brokers, the fee is usually paid in the form of commission rather than a flat fee.  Neither insurance consultants nor insurance brokers provide coverage and no risks are transferred to them.

The financial stability of an insurance company is a major consideration when purchasing an insurance policy. Premiums provide coverage for losses that might arise years in the future so the viability of the insurance carrier is very important. Recently many insurance companies have become insolvent, leaving their policyholders with no coverage. A number of independent rating agencies, such as Standard & Poor's, and Moody's, rate the viability of insurance companies and provide further information on this topic.

Controversies

Some academics and businesses have argued that by creating a "security blanket" for its customers, insurance may cause policy holders to not be as risk-averse as they would be. This problem is known as a moral hazard. To reduce their own risk, insurance companies have contractual agreements that mitigate their obligation to provide coverage if the clients demonstrate behavior that increases their risk of liability.  For example, life insurance businesses often require larger premiums or deny coverage altogether to people who work in hazardous occupations.

Insurance policies can be long and complex and some policyholders do not appreciate all the obligations in a policy. As a result, many people buy policies with unfavorable terms. In response to these issues, many countries have enacted detailed regulations governing every aspect of the insurance business specifying minimum standards for coverage and regulating the ways policies can be advertised and sold.

Many insurance policies in the English language have been carefully drafted in plain English because the industry learned the hard way that many courts will not enforce policies against claiments when the judges themselves cannot understand what the policies are communicating.

Most large organizations buy insurance through brokers. Brokers represent the buyer and typically counsel the buyer on policy limitations and appropriate coverage. A broker usually has contacts with many insurance companies, which allows the broker to shop around for the best rates and coverage.