Insurance is the equitable transfer of the risk of a loss, from
one entity to another in exchange for payment. It is a form of risk management primarily
used to hedge against
the risk of a contingent, uncertain loss.
An
insurer, or insurance carrier, is a company selling the insurance; the insured,
or policyholder, is the person or entity buying the insurance policy. The
amount to be charged for a certain amount of insurance coverage is called the
premium. Risk
management, the practice of appraising and
controlling risk, has evolved as a discrete field of study and practice.
The
transaction involves the insured assuming a guaranteed and known relatively
small loss in the form of payment to the insurer in exchange for the insurer's
promise to compensate (indemnify)
the insured in the case of a financial (personal) loss. The insured receives
a contract, called
the insurance
policy, which details the conditions and circumstances under which
the insured will be financially compensated.
Principles
Insurance
involves pooling funds
from many insured entities (known as exposures) to pay for the
losses that some may incur. The insured entities are therefore protected from
risk for a fee, with the fee being dependent upon the frequency and severity of
the event occurring. In order to be insurable, the risk insured against must
meet certain characteristics in order to be an insurable risk. Insurance is a commercial
enterprise and a major part of the financial services industry, but individual
entities can also self-insure through
saving money for possible future losses.
Insurability
Risk which
can be insured by private companies typically share seven common
characteristics:
1.
Large
number of similar exposure units:
Since insurance operates through pooling resources, the majority of insurance
policies are provided for individual members of large classes, allowing
insurers to benefit from the law of large numbers in
which predicted losses are similar to the actual losses. Exceptions
include Lloyd's of London,
which is famous for insuring the life or health of actors, sports figures and
other famous individuals. However, all exposures will have particular
differences, which may lead to different premium rates.
2.
Definite
loss: The loss takes place at a known
time, in a known place, and from a known cause. The classic example is death of
an insured person 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.
3.
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 or even
purchasing a lottery ticket, are generally not considered insurable.
4.
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 hardly any
point in paying such costs unless the protection offered has real value to a
buyer.
5.
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
the insurance will be purchased, 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 USFinancial
Accounting Standards Board standard number
113)
6.
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.
7.
Limited
risk of catastrophically large losses:
Insurable losses are ideally independent and
non-catastrophic, meaning that the losses do not happen all at once and
individual losses are not severe enough to bankrupt the insurer; insurers may
prefer to limit their exposure to a loss from a single event to some small
portion of their capital base. Capital constrains
insurers' ability to sell earthquake insurance as
well as wind insurance in hurricane zones. In the US, flood risk is insured by the federal
government. 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.
Legal
When a
company insures an individual entity, there are basic legal requirements.
Several commonly cited legal principles of insurance include:
1.
Indemnity – the insurance company
indemnifies, or compensates, the insured in the case of certain losses only up
to the insured's interest.
2.
Insurable interest –
the insured typically must directly suffer from the loss. Insurable interest
must exist whether property insurance or insurance on a person is involved. The
concept requires that the insured have a "stake" in the loss or
damage to the life or property insured. What that "stake" is will be
determined by the kind of insurance involved and the nature of the property
ownership or relationship between the persons. The requirement of an insurable
interest is what distinguishes insurance from gambling.
3.
Utmost good faith – the insured and the insurer are
bound by a good faith bond
of honesty and fairness. Material facts must be disclosed.
4.
Contribution – insurers which have similar
obligations to the insured contribute in the indemnification, according to some
method.
5.
Subrogation – the insurance company
acquires legal rights to pursue recoveries on behalf of the insured; for
example, the insurer may sue those liable for insured's loss.
6.
Causa proxima, or proximate cause –
the cause of loss (the peril) must be covered under the insuring agreement of
the policy, and the dominant cause must not be excluded
7.
Mitigation - In case of any loss or
casualty, the asset owner must attempt to keep loss to a minimum, as if the
asset was not insured.
Indemnification
Main
article: Indemnity
To
"indemnify" means to make whole again, or to be reinstated to the
position that one was in, to the extent possible, prior to the happening of a
specified event or peril. Accordingly, life insuranceis generally not considered to
be indemnity insurance, but rather "contingent" insurance (i.e., a
claim arises on the occurrence of a specified event). There are generally three
types of insurance contracts that seek to indemnify an insured:
1.
a "reimbursement" policy,
and
2.
a "pay on behalf" or
"on behalf of" policy, and
3.
an "indemnification"
policy.
From an
insured's standpoint, the result is usually the same: the insurer pays the loss
and claims expenses.
If the
Insured has a "reimbursement" policy the insured can be required to
pay for a loss and then be "reimbursed" by the insurance carrier for
the loss and out of pocket costs including, with the permission of the insurer,
claim expenses.
Under a
"pay on behalf" policy, the insurance carrier would defend and pay a
claim on behalf of the insured who would not be out of pocket for anything.
Most modern liability insurance is written on the basis of "pay on
behalf" language which enables the insurance carrier to manage and control
the claim.
Under an
"indemnification" policy the insurance carrier can generally either
"reimburse" or "pay on behalf of" whichever is more
beneficial to it and the insured in the claim handling process.
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 acontract, called an insurance policy. Generally, an insurance contract
includes, at a minimum, the following elements: identification of participating
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),
andexclusions (events
not covered). An insured is thus said to be "indemnified" against the loss 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
(called reserves), the remaining margin is an insurer's profit.
Effects
Insurance
can have various effects on society through the way that it changes who bears
the cost of losses and damage. On one hand it can increase fraud, on the other
it can help societies and individuals prepare for catastrophes and mitigate the
effects of catastrophes on both households and societies.
Insurance
can influence the probability of losses through moral hazard, insurance fraud, and preventive steps by the
insurance company. Insurance scholars have typically used morale hazard to refer to the increased
loss due to unintentional carelessness and moral hazard to refer to increased
risk due to intentional carelessness or indifference.[6] Insurers attempt to address
carelessness through inspections, policy provisions requiring certain types of
maintenance, and possible discounts for loss mitigation efforts. While in
theory insurers could encourage investment in loss reduction, some commentators
have argued that in practice insurers had historically not aggressively pursued
loss control measures - particularly to prevent disaster losses such as
hurricanes - because of concerns over rate reductions and legal battles.
However, since about 1996 insurers began to take a more active role in loss
mitigation, such as through building codes.
