Introduction
In insurance, the insured makes payments called
"premiums" to an insurer, and in return is able to
claim a payment from the insurer if the insured suffers a
defined type of loss. This relationship is usually drawn up in a
formal legal contract, also known as a policy. The contract will
set out in detail the exact circumstances under which a benefit
payment will be made and the amount of the premiums.
In one classic example of insurance, a ship-owner insures a
ship and receives payment if the ship is damaged or destroyed.
This example is one of the earliest uses and developments of
concepts like insurance. Interestingly, ships are now more often
insured through risk pooling and spreading organizations such as
Lloyd's of London because the loss of a large ship going down is
too great for one insurer to accept.
In the case of annuities, such as a pension, similar concepts
apply, but in some sense in the reverse. When applied to
annuities, the terms risk and loss are somewhat different from
traditional insurance as they concern the chances of living
beyond life expectancy and the need for income during the period
between annuitization and death.
Insurance attempts to quantify risk by pooling together a
large number of risks. This makes use of the law of large
numbers. As applied to insurance, this means that the greater
the number of similar risks, the greater accuracy with which
insurers can estimate the overall risk.
For example, many individual people purchase health insurance
policies and they each pay a small monthly or yearly premium to
an insurance company. When a policyholder gets ill, the
insurance company provides money to cover medical treatment. For
some individuals the insurance benefits may total far more money
than they have ever paid into the insurance policy. Others may
never make a claim. When averaged out over all of the people
buying policies, value of the claims even out. Insurance
companies set their premiums based on their calculated payouts.
They plan to take in more money (in premiums and in profit from
the float, see below) than they pay out in the end to cover
expenses. For-profit insurance companies set their rates to make
a profit rather than to break even.
Insurance companies also earn investment profits, because
they have the use of the premium money from the time they
receive it until the time they need it to pay claims. This money
is called the float. When the investments of float are
successful, they may earn large profits, even if the insurance
company pays out in claims every penny received as premiums. In
fact, most insurance companies pay out more money than they
receive in premiums. The excess amount that they pay to
policyholders is the cost of float. An insurance company will
profit if they invest the money at a greater return than their
cost of float.
Insurance can also be thought of as a wager or bet that
executes over the policy period. The insurance company bets that
you or your property will not suffer a loss while you put money
on the opposite outcome. The difference in the fees paid to the
insurance company vs the amount they can be held liable for if
an accident happens is roughly analagous to the odds one might
expect when betting on a racehorse, i.e 10:1. For this reason, a
number of religious groups including the Amish avoid insurance
and instead depend support provided by their communities when
disasters strike. In closing, supportive communities where
others will actually step in to rebuild lost property, this
arrangement can work. Most societies could not effectively
support this type of system.
History of insurance
Insurance has been an institution of human society for
thousands of years, having been practiced by Babylonian traders
as long ago as the 2nd millennium BCE. Eventually it was given
legal mention in the Code of Hammurabi, and practiced by early
Mediterranean sailing merchants. The Greeks and Romans had
"benevolent societies" which acted to care for the
families and funeral expenses of members upon death. Guilds in
the middle ages served a similar purpose. Insurance became much
more sophisticated in post-Renaissance Europe, and specialized
varieties developed. In America, Benjamin Franklin helped to
popularize and make standard the practice of insurance,
particularly against fire. The 19th century saw a rise in the
government regulation of insurance, and the 20th century saw
further specialization and, in the United States, a bit of
deregulation that allowed other financial institutions, such as
banks, to offer insurance. The ever-increasing ability of
science to predict catastrophes of any measure or variety
continues to affect the way insurance is conducted.
Types of insurance
Any risk that can be quantified probably has a type of
insurance to protect it. Among the different types of insurance
are:
- Automobile
insurance, also known as auto
insurance, car
insurance and in the UK as motor
insurance, is probably the most common form of insurance
and may cover both legal liability claims against the driver
and loss of or damage to the vehicle itself.
- Property
insurance provides protection against risks to property,
such as fire, theft or weather damage. This includes
specialized forms of insurance such as fire
insurance, flood
insurance, earthquake
insurance, home
insurance or boiler
insurance.
- Casualty
insurance insures against accidents, not necessarily
tied to any specific piece of property.
- Liability
insurance covers legal claims against the insured. For
example, a doctor may purchase insurance to cover any legal
claims against him if he were to be convicted of a mistake
in treating a patient.
- Financial
loss insurance protects individuals and companies
against various financial risks. For example, a business
might purchase cover to protect it from loss of sales if a
fire in a factory prevented it from carrying out its
business for a time. Insurance might also cover failure of a
creditor to pay money it owes to the insured. Fidelity
bonds and surety
bonds are included in this category.
- Title
insurance provides a guarantee on research done on public
records affecting title to real
property, usually in conjunction with a search done at
the time of a real
estate transaction, such as a sale, or a mortgage.
- Health
insurance covers medical bills incurred because of
sickness or accidents.
- Life
insurance provides a benefit to a decedent's family or
other designated beneficiary, to replace loss of the
insured's income
and provide for burial and other final expenses.
- Annuities
provide a stream of payments and are generally classified as
insurance because they are issued by insurance companies and
regulated as insurance. Annuities and pensions
that pay a benefit for life are sometimes regarded as
insurance against the possibility that a retiree will
outlive his or her financial resources. In that sense, they
are the opposite of life insurance.
- Credit
insurance pays some or all of a loan back when certain
things happen to the borrower like unemployment, disability,
or death.
- Terrorism
insurance
- Political
risk insurance can be taken out by businesses with
operations in countries in which there is a risk that
revolution or other political conditions will result in a
loss.
- Worker's
compensation insurance replaces all of part of a
worker's wages and accompanying medical expense lost due to
a job-related injury.
A single policy may cover risks in one or more of the above
categories. For example, car insurance would typically cover
both property risk (covering the risk of theft or damage to the
car) and liability risk (covering legal claims from say, causing
an accident). A homeowner's
insurance policy in the US typically includes property insurance
covering damage to the home and the owner's belongings,
liability insurance covering certain legal claims against the
owner, and even a small amount of health insurance for medical
expenses of guests who are injured on the owner's property.
Potential sources of risk that may give rise to claims are
known as perils.
Examples of perils might be fire, theft, earthquake, hurricane
and many other potential risks. An insurance policy will set out
in details which perils are covered by the policy and which are
not.
Types of insurance companies
Insurance companies may be classified as
- Life insurance companies, who sell life
insurance, annuities and pensions products.
- Non-life or general insurance companies,
who sell other types of insurance.
In most countries, life and non-life insurers are subject to
different regulations, tax and accounting rules. The main reason
for the distinction between the two types of company is that
life business is very long term in nature - coverage for life
assurance or a pension can cover risks over many decades. By
contrast, non-life insurance cover usually covers shorter
periods, such as one year.
Companies may sell both life and non life insurance, in which
case they are sometimes known as composite insurance
companies.
Insurance companies are also often classified as either mutual
or stock companies. This is more of a traditional
distinction as true mutual companies are becoming rare. Mutual
companies are owned by the policyholders, while stockholders,
(who may or may not own policies) own stock insurance companies.
Reinsurance companies sell insurance cover to other
insurance companies. This helps insurance companies to spread
their risks, and protects them from very large losses. The
reinsurance market is dominated by a few very large companies,
with huge reserves.
There are also companies which are known as Insurance
Brokers. Like a mortgage broker, these companies are paid a fee
by the customer to shop around for the best insurance policy
amongst many companies.
Life insurance and saving
As well as paying out a sum of money on death, many life
insurance contracts also pay out a sum of money after a given
time (in which case it is known as an endowment policy),
and may also pay out a cash value if the policy is cancelled
early. In many countries, such as the US and the UK, tax law
provides that the interest on this cash value is not taxable
under certain strict circumstances.
This leads to widespread use of life insurance as a
tax-efficient method of saving as well as protection in the
event of early death. Wealthy individuals buy life insurance
policies as a means for avoiding income taxes and estate taxes.
If the tax benefit exceeds the fees charged by the insurance
company for maintaining the policy, then the policy serves as a
life insurance tax shelter. There is much controversy
surrounding this practice, and the financial industry is deeply
divided about whether or not these practices work as advertised.
Criticisms of the insurance industry
Insurance insulates too much
By creating a "security blanket" for its insureds,
an insurance company may inadvertently find that its insureds
may not be as risk-averse as they should be (since they assume
they fallback upon their insurance policy). To reduce their own
financial exposure, insurance companies have contractual clauses
that remove their obligation to provide coverage if the insured
engages in some kind of behavior that grossly magnifies their
risk of loss or liability.
For example, liability insurance providers do not provide
coverage for liability arising from intentional torts committed
by the insured. Even if a provider was irrational enough to try
to provide such coverage, it is against the public policy of
most countries to allow such insurance to exist, and thus it is
usually illegal.
Lack of knowledge of policyholders
Insurance policies can be complex and some policyholders may
not understand all the fees included in a policy. As a result,
people could buy policies at unfavorable terms. In response to
these issues, governments often make detailed regulations that
set down minimum standards for policies and govern how they may
be advertised and sold.
Redlining
Location is one of the variables used to set rates. Insurers
are also starting to use credit "scores", occupation,
marital status, and education level to set rates. Many consider
these practices to be "unfair" and even racist. An
interesting refutation to this is that the job of an insurance
underwriter is to properly categorize a given risk as to the
likelihood that the loss will occur. Any factor that causes a
greater likelihood of loss should in theory, be charged a higher
rate. This is a basic principle of insurance and must be
followed for insurance companies or groups to operate properly,
even for non-profit groups. Thus, discrimination of potential
insureds by legitimate factors is central to insurance.
Therefore the only thing that can be considered legitimately
"unfair" are practices that discriminate against a
given group without actual factors that show that the group is a
higher risk.
Health insurance
Health insurance is one of the most controversial forms of
insurance because of the conflict between the need for the
insurance company to remain solvent versus the need of its
customers to remain healthy, which many view as a basic human
right. This conflict exists in a liberal healthcare system
because of the unpredictability of how patients respond to
medical treatment. Suppose a large number of customers of a
particular insurance company were to contract a rare disease
costing 100 million dollars to fight for each patient. The
insurance company would be faced with the choice of either
charging all its future customers astronomical premiums (thus
losing customers and going out of business), paying all claims
without complaint (thus going out of business) or fighting the
customers in an attempt to deny the costly treatment (thus
outraging patients and their families, and becoming a target for
lawsuits and legislation).
Many countries have made the choice to avoid this important
conflict by nationalizing the health industry so that doctors,
nurses, and other medical workers become state employees, all or
partly funded by taxes; or setting up a national health
insurance plan that all citizens pay into with tax payments, and
which pays private doctors for health care. These national
health care systems also have their problems. Many countries
have citizen groups which protest bureaucracy and cost-cutting
measures that sometimes unduly delay medical treatment.
In the United States, health insurance is made more complicated
by Federal Medicare/Medicaid programs, which have had the
unintended consequence of determining the price of medical
procedures. Many suspect that these prices are set independently
of medical necessity or actual cost. A physician who refuses to
accept a Medicare/Medicaid payment will be banned from accepting
any such payments for a number of years, regardless of the
reason for rejecting the payment or the amount offered. In
either case, this means that private insurers have little
incentive to pay more than the government does.
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