Define: Insurance

Quick Summary of Insurance

Insurance is a financial arrangement where an individual or entity pays a premium to an insurance company in exchange for protection against potential financial losses or liabilities. In the event of covered risks such as accidents, illnesses, property damage, or other unforeseen events, the insurance company compensates the policyholder or beneficiaries according to the terms of the insurance contract. Insurance provides individuals and businesses with a safety net, helping them manage risks and uncertainties by spreading the financial burden across a larger pool of policyholders. Common types of insurance include health insurance, auto insurance, homeowners insurance, life insurance, and business insurance, each tailored to specific risks and needs.

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 the company that sells 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. There are 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. 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.
2. 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 the 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.
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, 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 and 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 the buyer.
5. Affordable Premium. If the likelihood of an insured event is so high or the cost of the event is 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 it is on offer. Further, as the accounting profession formally recognises 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)
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. There is a 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 a 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 insurer’s 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 coastal 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 constraints. 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” 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 $10,000 to pay for the visitor’s fall and then be “indemnified” by the insurance carrier for the out-of-pocket costs (the $10,000).

Under the same situation, under 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.

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, and 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 the 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 difficult 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 analysed to fairly accurately project the rate of future claims based on a given risk. Actuarial science uses statistics and probability to analyse 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 per cent indicates underwriting profitability, while anything over 100 indicates an underwriting loss.

Insurance companies also earn investment profits on “floats.”. “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 paid out in claims. Insurers start investing in 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 in 2003. But overall profit for the same period was $68.4 billion as a result of the float. Some insurance industry insiders, most notably Hank Greenberg, do not believe that it is forever possible to sustain a profit from a 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.

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 in this line of business has greatly benefited from advances in computing. Additionally, property losses in the US due to natural catastrophes have exacerbated this trend.

Finally, claim and loss handling is the materialised 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 a 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 (the 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: “Whenever 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 would receive an amount of twice as much.”

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 a storm or sinkage.

The Greeks and Romans introduced the origins of health and life insurance c. 600 AD when they organised guilds called “benevolent societies,” which cared for 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 specialised varieties developed.

Towards 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 popularise and standardise 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 towards 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 centralised nationally and internationally, state insurance commissioners operate individually, though at times in concert through a national insurance commissioners’ organisation. In recent years, some have called for a dual state and federal regulatory system for insurance similar to that which oversees state banks and national banks.

In the state of New York, which has unique laws in keeping with its stature as a global business centre, former New York Attorney General Eliot Spitzer was 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 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 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.

Life & Annuity Coverages

• 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, 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.

Health Coverages

• Health insurance policies will often cover the cost of private medical treatments if the National Health Service in the UK (NHS) or other publicly-funded health programmes 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.

Disability Coverages

• 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 provides benefits when a person is permanently disabled and can no longer work in their profession. It is 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 lost wages and accompanying medical expense incurred because of a job-related injury.

Property & Casualty Coverages

Property insurance provides protection against risks to property, such as fire, theft or weather damage. This includes specialised forms of insurance such as fire insurance, flood insurance, earthquake insurance, home insurance, inland marine insurance or boiler insurance.

Casualty insurance insures against accidents, not necessarily tied to any specific property.

• 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 authorised driver whilst undergoing tuition; unlike other motor policies, it also provides cover for instructor liability, where both the pupil and driving instructor are equally liable in the event of a claim.
• Aviation insurance insures against hull, spares, deductible, hull wear and liability risks.
• Boiler insurance (also known as boiler and machinery insurance or equipment breakdown insurance) insures against accidental physical damage to equipment or machinery.
• Builder’s risk insurance insures against the risk of physical loss or damage to property during construction. Builder’s risk insurance is typically written on an “all-risk” basis, covering damage due to any cause (including the negligence of the insured) not otherwise expressly excluded.
• 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.
• Crop insurance “Farmers use crop insurance to reduce or manage various risks associated with growing crops. Such risks include crop loss or damage caused by weather, hail, drought, frost damage, insects, or disease, for instance.”
• Earthquake insurance is a form of property insurance that pays the policyholder in the event of an earthquake that causes damage to the property. Most ordinary homeowners insurance policies do not cover earthquake damage. Most earthquake insurance policies feature a high deductible. Rates depend on location and the probability of an earthquake, as well as the construction of the home.
• A fidelity bond is a form of casualty insurance that covers policyholders for losses that they incur as a result of fraudulent acts by specified individuals. It usually insures a business for losses caused by the dishonest acts of its employees.
• Fire insurance: See “Property insurance”.
• Flood insurance protects against property loss due to flooding. Many insurers in the US do not provide flood insurance in some portions of the country. In response to this, the federal government created the National Flood Insurance Programme, which serves as the insurer of last resort.
• Hazard insurance: See “Property insurance”.
• Home insurance or homeowners insurance: See “Property insurance”.
• Marine insurance and marine cargo insurance cover the loss or damage of ships at sea or on inland waterways, as well as the cargo that may be on them. When the owner of the cargo and the carrier are separate corporations, marine cargo insurance typically compensates the owner of cargo for losses sustained from fire, shipwreck, etc. but excludes losses that can be recovered from the carrier or the carrier’s insurance. Many marine insurance underwriters will include “time element” coverage in such policies, which extends the indemnity to cover loss of profit and other business expenses attributable to the delay caused by a covered loss.
• Political risk insurance is a form of casualty insurance that can be taken out by businesses with operations in countries where there is a risk that revolution or other political conditions will result in a loss.
• Surety bond insurance is three-party insurance guaranteeing the performance of the principal.
• Terrorism insurance provides protection against any loss or damage caused by terrorist activities.
• Volcano insurance is an insurance policy that covers volcano damage in Hawaii.
• Windstorm insurance is an insurance policy covering the damage that can be caused by hurricanes and tropical cyclones.

Liability Coverages

Liability insurance is a very broad superset that covers legal claims against the insured. Many types of insurance include an aspect of liability coverage. For example, a homeowner’s insurance policy will normally include liability coverage, which protects the insured in the event of a claim brought by someone who slips and falls on the property; automobile insurance also includes an aspect of liability insurance that indemnifies against the harm that a crashing car can cause to others’ lives, health, or property. The protection offered by a liability insurance policy is twofold: a legal defence in the event of a lawsuit commenced against the policyholder and indemnification (payment on behalf of the insured) with respect to a settlement or court verdict. Liability policies typically cover only the negligence of the insured and will not apply to results of wilful or intentional acts by the insured.

• Environmental liability insurance protects the insured from bodily injury, property damage and clean-up costs as a result of the dispersal, release or escape of pollutants.
• Errors and omissions insurance: See “Professional liability insurance” under “Liability insurance.
• Professional liability insurance, also called professional indemnity insurance, protects professional practitioners such as architects, lawyers, doctors, and accountants against potential negligence claims made by their patients/clients. Professional liability insurance may take on different names depending on the profession. For example, professional liability insurance in reference to the medical profession may be called malpractice insurance. Notaries public may take out errors and omissions insurance (E&O). Other potential E&O policyholders include, for example, real estate brokers, home inspectors, appraisers, and website developers.
• Directors and officers liability insurance protects an organisation (usually a corporation) from costs associated with litigation resulting from mistakes incurred by directors and officers for which they are liable. In the industry, it is usually called “D&O” for short.
• Prize indemnity insurance protects the insured from giving away a large prize at a specific event. Examples would include offering prizes to contestants who can make a half-court shot at a basketball game or a hole-in-one at a golf tournament.

Credit Coverages

• Credit insurance repays some or all of a loan when certain things happen to the borrower, such as unemployment, disability, or death. Mortgage insurance is a form of credit insurance, although the name credit insurance more often is used to refer to policies that cover other kinds of debt.
• Mortgage insurance insures the lender against default by the borrower.

Other Types Of Coverage

• Defence Base Act Workers’ Compensation, or DBA Insurance, provides coverage for civilian workers hired by the government to perform contracts outside the US and Canada. DBA is required for all US citizens, US residents, US Green Card holders, and all employees or subcontractors hired on overseas government contracts. Depending on the country, Foreign Nationals must also be covered under DBA. This coverage typically includes expenses related to medical treatment and loss of wages, as well as disability and death benefits.
• Expatriate insurance provides individuals and organisations operating outside of their home country with protection for automobiles, property, health, liability and business pursuits.
• 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 the failure of a creditor to pay money it owes to the insured. This type of insurance is frequently referred to as “business interruption insurance.” Fidelity bonds and surety bonds are included in this category, although these products provide a benefit to a third party (the “obligee”) in the event the insured party (usually referred to as the “obligor”) fails to perform its obligations under a contract with the obligee.
• Kidnap and ransom 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. The terms of this type of insurance are usually very strict. Therefore, it is used only in extreme cases where maximum security of funds is required.
• Nuclear incident insurance covers damages resulting from an incident involving radioactive materials and is generally arranged at the national level. (For the United States, see the Price-Anderson Nuclear Industries Indemnity Act.)
• Pet insurance insures pets against accidents and illnesses; some companies cover routine/wellness care and burial as well.
• Pollution Insurance. first-party coverage for contamination of insured property either by external or on-site sources. Coverage for liability to third parties arising from contamination of air, water, or land due to the sudden and accidental release of hazardous materials from the insured site. The policy usually covers the costs of clean-up and may include coverage for releases from underground storage tanks. Intentional acts are specifically excluded.
• Purchase insurance is aimed at providing protection on the products people purchase. Purchase insurance can cover individual purchase protection, warranties, guarantees, care plans and even mobile phone insurance. Such insurance is normally very limited in the scope of problems that are covered by the policy.
• 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 performed at the time of a real estate transaction.
• Travel insurance is an insurance policy taken by those who travel abroad which covers certain losses, such as medical expenses, loss of personal belongings, travel delay, personal liabilities, etc.

Types Of Insurance-Financing Vehicles

• Protected Self-Insurance is an alternative risk financing mechanism in which an organisation retains the mathematically calculated cost of risk within the organisation and transfers the catastrophic risk with specific and aggregate limits to an insurer, so the maximum total cost of the programme is known. A properly designed and underwritten Protected Self-Insurance Programme reduces and stabilises the cost of insurance and provides valuable risk management information.
• Retrospectively Rated Insurance is a method of establishing a premium on large commercial accounts. The final premium is based on the insured’s actual loss experience during the policy term, sometimes subject to a minimum and maximum premium, with the final premium determined by a formula. Under this plan, the current year’s premium is based partially (or wholly) on the current year’s losses, although the premium adjustments may take months or years beyond the current year’s expiration date. The rating formula is guaranteed in the insurance contract. Formula: retrospective premium = converted loss + basic premium × tax multiplier. Numerous variations of this formula have been developed and are in use.
• Fraternal insurance is provided on a cooperative basis by fraternal benefit societies or other social organisations.
• Formal self-insurance is the deliberate decision to pay for otherwise insurable losses out of one’s own money. This can be done on a formal basis by establishing a separate fund into which funds are deposited on a periodic basis or by simply forgoing the purchase of available insurance and paying out-of-pocket. Self-insurance is usually used to pay for high-frequency, low-severity losses. Such losses, if covered by conventional insurance, mean having to pay a premium that includes loadings for the company’s general expenses, the cost of putting the policy on the books, acquisition expenses, premium taxes, and contingencies. While this is true for all insurance, for small, frequent losses, the transaction costs may exceed the benefit of volatility reduction that insurance otherwise affords.
• No-fault insurance is a type of insurance policy (typically automobile insurance) where insureds are indemnified by their own insurer regardless of fault in the incident.
• Reinsurance is a type of insurance purchased by insurance companies or self-insured employers to protect against unexpected losses. Financial reinsurance is a form of reinsurance that is primarily used for capital management rather than to transfer insurance risk.
• Stop-loss insurance provides protection against catastrophic or unpredictable losses. It is purchased by organisations that do not want to assume 100% of the liability for losses arising from the plans. Under a stop-loss policy, the insurance company becomes liable for losses that exceed certain limits called deductibles.
• Social insurance can be many things to many people in many countries. But a summary of its essence is that it is a collection of insurance coverages (including components of life insurance, disability income insurance, unemployment insurance, health insurance, and others) plus retirement savings that mandates participation by all citizens. By forcing everyone in society to be a policyholder and pay premiums, it ensures that everyone can become a claimant when or if he/she needs to. Along the way, this inevitably becomes related to other concepts, such as the justice system and the welfare state. This is a large, complicated topic that engenders tremendous debate, which can be further studied in the following articles (and others):
  • Social welfare provision
  • Social security
  • Social safety net
  • National Insurance
  • Social Security (United States)
  • Social Security debate (United States)

Types Of Insurance Companies

Insurance companies may be classified as

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

General insurance companies can be further divided into these subcategories.

• Standard Lines
• Excess Lines

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

In the United States, standard-line insurance companies are your “mainstream” insurers. These are the companies that typically insure your auto, home, or business. They use pattern or “cookie-cutter” policies without variation from one person to the next. They usually have lower premiums than excess lines and can sell directly to individuals. They are regulated by state laws that can restrict the amount they can charge for insurance policies.

Excess line insurance companies (aka Excess and Surplus) typically insure risks not covered by the standard line market. They are broadly referred to as all insurance placed with non-admitted insurers. Non-admitted insurers are not licenced in the states where the risks are located. These companies have more flexibility and can react faster than standard insurance companies because they are not required to file rates and forms as the “admitted” carriers do. However, they still have substantial regulatory requirements placed on them. State laws generally require insurance placed with surplus line agents and brokers to not be available through standard licenced insurers.

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. Other possible forms for an insurance company include reciprocals, in which policyholders’reciprocate’ in sharing risks, and Lloyds organisations.

Insurance companies are rated by various agencies, such as A.M. Best. The ratings include the company’s financial strength, which measures its ability to pay claims. It also rates financial instruments issued by the insurance company, such as bonds, notes, and securitization products.

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. A reinsurer may also be a direct writer of insurance risks as well.

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 to the parent company’s customers. In short, it is an in-house self-insurance vehicle. Captives may take the form of a “pure” entity (which is a 100 percent subsidiary of the self-insured parent company), a “mutual” captive (which insures the collective risks of members of an industry), or an “association” captive (which self-insures the individual risks of the members of a professional, commercial, or industrial association). Captives represent commercial, economic, and tax advantages to their sponsors because of the reductions in costs they help create, the ease of insurance risk management, and the flexibility for cash flows they generate. Additionally, they may provide coverage for risks that are neither available nor offered in the traditional insurance market at reasonable prices.

The types of risk that a captive can underwrite for their parents 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.

Neither insurance consultants nor insurance brokers are insurance companies and no risks are transferred to them in insurance transactions.

Third-party administrators are companies that perform underwriting and sometimes claims handling services for insurance companies. These companies often have special expertise that insurance companies do not have.

Life Insurance And Savings

Certain life insurance contracts accumulate cash values, which may be taken by the insured if the policy is surrendered or borrowed against. Some policies, such as annuities and endowment policies, are financial instruments to accumulate or liquidate wealth when it is needed.

Further information: Life insurance

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 the widespread use of life insurance as a tax-efficient method of saving as well as protection in the event of early death.

In the 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 insurance company, the type of policy and other variables (mortality, market return, etc.). Moreover, other income-tax-saving vehicles (e.g., IRAs, 401(k) plans, and Roth IRAs) may be better alternatives for value accumulation. A combination of low-cost term life insurance and a tax-efficient retirement account may achieve better investment return.

Size Of Global Insurance Industry

Global insurance premiums grew by 9.7 per cent in 2004 to reach $3.3 trillion. This follows 11.7 per cent growth in the previous year. Life insurance premiums grew by 9.8 per cent during the year, thanks to rising demand for annuity and pension products. Non-life insurance premiums grew by 9.4 per cent, as premium rates increased. Over the past decade, global insurance premiums rose by more than a half as annual growth fluctuated between 2 per cent and 10 per cent.

Advanced economies account for the bulk of global insurance. With premium income of $1,217 billion in 2004, North America was the most important region, followed by the EU (at $1,198 billion) and Japan (at $492 billion). The top four countries accounted for nearly two-thirds of premiums in 2004. The United States and Japan alone accounted for a half of world insurance premiums, much higher than their 7 per cent share of the global population. Emerging markets accounted for over 85 per cent of the world’s population but generated only 10 per cent of premiums. The volume of UK insurance business totalled $295 billion in 2004 or 9.1 per cent of global premiums.

Financial Viability Of Insurance Companies

Financial stability and strength of an 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 or other arrangement with less attractive pay-outs for losses). A number of independent rating agencies, such as Best’s, Fitch, Standard & Poor’s, and Moody’s Investors Service, provide information and rate the financial viability of insurance companies.

Accounting Definition (United States)

An operational definition of insurance is that it is

• the benefit provided by a particular kind of indemnity contract, called an insurance policy;
• that is issued by one of several kinds of legal entities (stock insurance company, mutual insurance company, reciprocal, or Lloyd’s syndicate, for example), any of which may be called an insurer;
• in which the insurer promises to pay on behalf of or to indemnify another party, called a policyholder or insured;
• that protects the insured against loss caused by those perils subject to the indemnity in exchange for consideration known as an insurance premium.

In recent years this kind of operational definition proved inadequate as a result of contracts that had the form but not the substance of insurance. The essence of insurance is the transfer of risk from the insured to one or more insurers. How much risk a contract actually transfers proved to be at the heart of the controversy.

This issue arose most clearly in reinsurance, where the use of Financial Reinsurance to reengineer insurer balance sheets under US GAAP became fashionable during the 1980s. The accounting profession raised serious concerns about the use of reinsurance in which little if any actual risk was transferred, and went on to address the issue in FAS 113, cited above. While on its face, FAS 113 is limited to accounting for reinsurance transactions, the guidance it contains is generally conceded to be equally applicable to US GAAP accounting for insurance transactions executed by commercial enterprises.

Risk Transfer Requirement

FAS 113 contains two tests, called the ‘9a and 9b tests,’ that collectively require that a contract create a reasonable chance of a significant loss to the underwriter for it to be considered insurance.

9. Indemnification of the ceding enterprise against loss or liability relating to insurance risk in reinsurance of short-duration contracts requires both of the following, unless the condition in paragraph 11 is met:

a. The reinsurer assumes significant insurance risk under the reinsured portions of the underlying insurance contracts.

b. It is reasonably possible that the reinsurer may realise a significant loss from the transaction.

Paragraph 10 of FAS 113 makes clear that the 9a and 9b tests are based on comparing the present value of all costs to the PV of all income streams. FAS gives no guidance on the choice of a discount rate on which to base such a calculation, other than to say that all outcomes tested should use the same rate.

Statement of Statutory Accounting Principles (“SSAP”) 62, issued by the National Association of Insurance Commissioners, applies to so-called ‘statutory accounting’ – the accounting for insurance enterprises to conform with regulation. Paragraph 12 of SSAP 62 is nearly identical to the FAS 113 test, while paragraph 14, which is otherwise very similar to paragraph 10 of FAS 113, additionally contains a justification for the use of a single fixed rate for discounting purposes. The choice of an “reasonable and appropriate” discount rate is left as a matter of judgement.

No Bright-line Test

Neither FAS 113 nor SAP 62 defines the terms reasonable or significant. Ideally, one would like to be able to substitute values for both terms. It would be much simpler if one could apply a test of an X per cent chance of a loss of Y per cent or greater. Such tests have been proposed, including one famously attributed to an SEC official who is said to have opined in an after-lunch talk that a 10 per cent chance of a 10 per cent loss was sufficient to establish both reasonableness and significance. Indeed, many insurers and reinsurers still apply this 10/10″ test as a benchmark for risk transfer testing.

It should be obvious that an attempt to use any numerical rule such as the 10/10 test will quickly run into problems. Implicit in the test is keeping the 10/10 that either are upper bonds for the comment made by the SEC official therefore, the rest of this paragraph doesn’t apply. Suppose a contract has a 1 per cent chance of a 10,000 per cent loss? It should be reasonably self-evident that such a contract is insurance, but it fails one half of the 10/10 test.

It does not appear that any bright-line test of reasonableness nor significance can be constructed.

Excess of loss contracts, like those commonly used for umbrella and general liability insurance, or to insure against property losses, will typically have a low ratio of premium paid to maximum loss recoverable. This ratio (expressed as a percentage), commonly called the rate on line for historical reasons related to underwriting practices at Lloyd’s of London, will typically be low for contracts that contain reasonably self-evident risk transfer. As the ratio increases to approximate the present value of the limit of coverage, self-evidence decreases and disappears.

Contracts with low rates on line may survive modest features that limit the amount of risk transferred. As rates on line increase, such risk-limiting features become increasingly important.

“Safe Harbour” Exemptions

The analysis of reasonableness and significance is an estimate of the probability of different gain or loss outcomes under different loss scenarios. It takes time and resources to perform the analysis, which constitutes a burden without value where risk transfer is reasonably self-evident.

Guidance exists for insurers and reinsurers, whose CEO’s and CFO’s attest annually as to the reinsurance agreements their firms undertake. The American Academy of Actuaries, for instance, identifies three categories of contract as outside the requirement of attestation:

• Inactive contracts. If there are no premiums due nor losses payable, and the insurer is not taking any credit for the reinsurance, determining risk transfer is irrelevant.
• Pre-1994 contracts. The attestation requirement only applies to contracts that were entered into, renewed or amended on or after 1 January 1994. Prior contracts need not be analysed.
• Where risk transfer is “reasonably self-evident.”

Risk Limiting Features

An insurance policy should not contain provisions that allow one side or the other to unilaterally void the contract in exchange for benefit. Provisions that void the contract for failure to perform or for fraud or material misrepresentation are ordinary and acceptable.

The policy should have a term of not more than about three years. This is not a hard and fast rule. Contracts of over five years duration are classified as ‘long-term,’ which can impact the accounting treatment, and can obviously introduce the possibility that over the entire term of the contract, no actual risk will transfer. The coverage provided by the contract need not cease at the end of the term (e.g., the contract can cover occurrences as opposed to claims made or claims paid).

The contract should be considered to include any other agreements, written or oral, that confer rights, create obligations, or create benefits on the part of either or both parties. Ideally, the contract should contain an ‘Entire Agreement’ clause that assures there are no undisclosed written or oral side agreements that confer rights, create obligations, or create benefits on the part of either or both parties. If such rights, obligations or benefits exist, they must be factored into the tests of reasonableness and significance.

The contract should not contain arbitrary limitations on timing of payments. Provisions that assure both parties of time to properly present and consider claims are acceptable provided they are commercially reasonable and customary.

Provisions that expressly create actual or notional accounts that accrue actual or notional interest suggest that the contract contains, in fact, a deposit.

Provisions for additional or return premium do not, in and of themselves, render a contract something other than insurance. However, it should be unlikely that either a return or additional premium provision be triggered, and neither party should have discretion regarding the timing of such triggering.

All of the events that would give rise to claims under the contract cannot have materialized prior to the inception of the contract. If this “all events” test is not met, then the contract is considered to be a retroactive contract, for which the accounting treatment becomes complex.

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 might otherwise be (since, by definition, the insured has transferred the risk to the insurer). This problem is known to the insurance industry as a 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 behaviour that grossly magnifies their risk of loss or liability.

For example, life insurance companies may require higher premiums or deny coverage altogether to people who work in hazardous occupations or engage in dangerous sports. Liability insurance providers do not provide coverage for liability arising from intentional torts committed by the insured. Even if a provider were so irrational as to desire 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.

Closed Community Self-Insurance

Some communities prefer to create virtual insurance amongst themselves by other means than contractual risk transfer, which assigns explicit numerical values to risk. A number of religious groups, including the Amish and some Muslim groups, depend on support provided by their communities when disasters strike. The risk presented by any given person is assumed collectively by the community who all bear the cost of rebuilding lost property and supporting people whose needs are suddenly greater after a loss of some kind. In supportive communities where others can be trusted to follow community leaders, this tacit form of insurance can work. In this manner, the community can even out the extreme differences in insurability that exist among its members. Some further justification is also provided by invoking the moral hazard of explicit insurance contracts.

In the United Kingdom, The Crown (which, for practical purposes, meant the Civil service) did not insure property such as government buildings. If a government building was damaged, the cost of repair would be met from public funds because, in the long run, this was cheaper than paying insurance premiums. Since many UK government buildings have been sold to property companies, and rented back, this arrangement is now less common and may have disappeared altogether.

Complexity Of Insurance Policy Contracts

Insurance policies can be complex and some policyholders may not understand all the fees and coverages included in a policy. As a result, people may buy policies on unfavourable terms. In response to these issues, many countries have enacted detailed statutory and regulatory regimes governing every aspect of the insurance business, including minimum standards for policies and the ways in which they may be advertised and sold.

Many institutional insurance purchasers buy insurance through an insurance broker. Brokers represent the buyer (not the insurance company), and typically counsel the buyer on appropriate coverages, policy limitations. A broker generally holds contracts with many insurers, thereby allowing the broker to “shop” the market for the best rates and coverage possible.

Insurance may also be purchased through an agent. Unlike a broker, who represents the policyholder, an agent represents the insurance company from whom the policyholder buys. An agent can represent more than one company.

Redlining

Redlining is the practice of denying insurance coverage in specific geographic areas, purportedly because of a high likelihood of loss, while the alleged motivation is unlawful discrimination. Racial profiling or redlining has a long history in the property insurance industry in the United States. From a review of industry underwriting and marketing materials, court documents, and research by government agencies, industry and community groups, and academics, it is clear that race has long affected and continues to affect the policies and practices of the insurance industry.

In determining premiums and premium rate structures, insurers consider quantifiable factors, including location, credit scores, gender, occupation, marital status, and education level. However, the use of such factors is often considered to be unfair or unlawfully discriminatory, and the reaction against this practice has in some instances led to political disputes about the ways in which insurers determine premiums and regulatory intervention to limit the factors used.

An insurance underwriter’s job is to evaluate a given risk as to the likelihood that a loss will occur. Any factor that causes a greater likelihood of loss should theoretically be charged a higher rate. This basic principle of insurance must be followed if insurance companies are to remain solvent. Thus, “discrimination” against (i.e., differential treatment of) potential insureds in the risk evaluation and premium-setting process is a necessary by-product of the fundamentals of insurance underwriting. For instance, insurers charge older people significantly higher premiums than they charge younger people for term life insurance. Older people are thus treated differently than younger people (i.e., a distinction is made, discrimination occurs). The rationale for the differential treatment goes to the heart of the risk a life insurer takes: Old people are likely to die sooner than young people, so the risk of loss (the insured’s death) is greater in any given period of time and therefore the risk premium must be higher to cover the greater risk. However, treating insureds differently when there is no actuarially sound reason for doing so is unlawful discrimination.

What is often missing from the debate is that prohibiting the use of legitimate, actuarially sound factors means that an insufficient amount is being charged for a given risk, and there is thus a deficit in the system. The failure to address the deficit may mean insolvency and hardship for all of a company’s insureds. The options for addressing the deficit seem to be the following: Charge the deficit to the other policyholders or charge it to the government (i.e., externalize outside of the company to society at large).

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 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 U.S. See health insurance & Health insurance in the United States.

Insurance Patents

New insurance products can now be protected from copying with a business method patent in the United States.

A recent example of a new insurance product that is patented is telematic auto insurance. It was independently invented and patented by a major U.S. auto insurance company, Progressive Auto Insurance and a Spanish independent inventor, Salvador Minguijon Perez (EP patent 0700009).

The basic idea of telematic auto insurance is that a driver’s behaviour is monitored directly while he or she drives and the information is transmitted to the insurance company. The insurance company uses the information to assess the likelihood that a driver will have an accident and adjusts premiums accordingly. A driver who drives great distances at high speeds, for example, might be charged a different rate than a driver who drives short distances at low speeds. The precise effect on charges is not known as it is not clear that a high-speed long-distance driver incurs greater risk to an insurance pool than the slow around-town driver.

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

Recent theoretical economic research on the social welfare effects of Progressive’s telematics technology business process patents have questioned whether the business process patents are Pareto efficient for society. Preliminary results suggest that they are not, but more work is needed.

Many independent inventors are in favour 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 per cent of the new U.S. 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, recently had to pay $80 million to an independent inventor, Bancorp Services, in order to settle a patent infringement and theft of trade secret lawsuit for a type of corporate-owned life insurance product invented and patented by Bancorp.

There are currently about 150 new patent applications on insurance inventions filed per year in the United States. The rate at which patents have issued has steadily risen from 15 in 2002 to 44 in 2006.

The Insurance Industry And Rent-Seeking

Certain insurance products and practices have been described as rent-seeking by critics. That is, some insurance products or practices are useful primarily because of legal benefits, such as reducing taxes, as opposed to providing protection against risks of adverse events. Under United States tax law, for example, most owners of variable annuities and variable life insurance can invest their premium payments in the stock market and defer or eliminate paying any taxes on their investments until withdrawals are made. Sometimes this tax deferral is the only reason people use these products. 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 themselves are immune from the estate tax.

Criticism Of Insurance Companies

Some people believe that modern insurance companies are money-making businesses which have little interest in insurance. They argue that the purpose of insurance is to spread risk so the reluctance of insurance companies to take on high-risk cases (e.g. houses in areas subject to flooding, or young drivers) runs counter to the principle of insurance.

Other criticisms include:

• Insurance policies contain too many exclusion clauses. For example, some house insurance policies do not cover damage to garden walls.
• Most insurance companies now use call centres and staff attempt to answer questions by reading from a script. It is difficult to speak to anybody with expert knowledge.

Disclaimer

This site contains general legal information but does not constitute professional legal advice for your particular situation. Persuing this glossary does not create an attorney-client or legal adviser relationship. If you have specific questions, please consult a qualified attorney licensed in your jurisdiction.

This glossary post was last updated: 8th April, 2024.