Insurance is a system to alleviate financial losses by transferring risk of loss from one entity to another.
The entity that is transferring the risk — which may be an individual or association of any type, including a government or government agency — is called the "insured". The entity accepting the risk is called the "insurer". The agreement between the two by which the risk is transferred is called the "policy": this is a legal contract that sets out exactly the terms and conditions of the coverage. The fee paid by the insured to the insurer for assuming the risk is called the "premium". This is usually determined by the insurer to fund estimated future claims paid, administrative costs, and profit.
For example, let us assume that a couple buys a home costing $100,000. Knowing that the loss of their home would bring them financial ruin, they acquire insurance coverage in the form of a homeowner's policy. That policy will pay them the cost of replacing or repairing their home in the event of a catastrophe. The insurance company charges them a premium of $1,000 a year. Risk of loss has been transferred from the homeowners to the insurance company.
The insurer uses actuarial science to quantify the risk they have assumed. Actuarial science uses mathematics, particularly statistics and probability, which can be applied to many covered risks to approximate future claims with reasonable accuracy.
For example, many individual people purchase homeowner's insurance policies and they each pay a premium to an insurance company. If a covered loss occurs, the insurer pays the claim. For some insureds, the insurance benefits they receive will greatly exceed the money they have paid to the insurer. Others may never make a claim. When averaged out over all the policies sold, the total of claims paid out should be less than the total of premiums paid to the insurer, with the difference being costs and profit.
Insurance companies also earn investment profits. These are generated by investing premiums received until they are needed to pay claims. This money is called the "float". The insurer may make profits or losses from the value change in the float as well as interest or dividend on the float. In the United States, the underwriting loss of property and casualty insurance companies was $142.3 billion in the five years ending 2003. But overall profit for the same period was $68.4 billion, at the result of float.
Some people consider insurance a type of 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 versus the amount for which they can be held liable if an accident happens is roughly analogous to the odds one might expect when betting on a racehorse (for example, 10 to 1). For this reason, a number of religious groups including the Amish avoid insurance and instead depend on support provided by their communities when disasters strike. In closed, supportive communities where others will actually step in to rebuild lost property, this arrangement can work. Most societies could not effectively support this type of system and the system will not work for large risks.
History of insurance
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. The Talmud deals with several aspects of insuring goods. Insurance became far 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.
In the United States, the insurance industry is highly regulated, primarily by the states, who operate both individually and in concert through a national insurance commissioner's organization.
Types of insurance
Any risk that can be quantified probably has a type of insurance to protect it. Among the different types of insurance are:
- Automobile insurance, also known as auto insurance, car insurance and in the UK as motor insurance, is probably the most common form of insurance and may cover both legal liability claims against the driver and loss of or damage to the vehicle itself.
- Casualty insurance insures against accidents, not necessarily tied to any specific property.
- Credit insurance pays some or all of a loan back when certain things happen to the borrower such as unemployment, disability, or death.
- Financial loss insurance protects individuals and companies against various financial risks. For example, a business might purchase cover to protect it from loss of sales if a fire in a factory prevented it from carrying out its business for a time. Insurance might also cover failure of a creditor to pay money it owes to the insured. Fidelity bonds and surety bonds are included in this category.
- Health insurance covers medical bills incurred because of sickness or accidents.
- Liability insurance covers legal claims against the insured. For example, a doctor may purchase insurance to cover any legal claims against him if he were to be convicted of a mistake in treating a patient.
- Life insurance provides a benefit to a decedent's family or other designated beneficiary, to replace loss of the insured's income and provide for burial and other final expenses.
- Annuities provide a stream of payments and are generally classified as insurance because they are issued by insurance companies and regulated as insurance. Annuities and pensions that pay a benefit for life are sometimes regarded as insurance against the possibility that a retiree will outlive his or her financial resources. In that sense, they are the complement of life insurance.
- Political risk insurance can be taken out by businesses with operations in countries in which there is a risk that revolution or other political conditions will result in a loss.
- Property insurance provides protection against risks to property, such as fire, theft or weather damage. This includes specialized forms of insurance such as fire insurance , flood insurance , earthquake insurance, home insurance or boiler insurance.
- Terrorism insurance
- Title insurance provides a guarantee that title to real property is vested in the purchaser and/or mortgagee, free and clear of liens or encumbrances. It is usually issued in conjunction with a search of the public records done at the time of a real estate transaction.
- Workers' compensation insurance replaces all or part of a worker's wages lost and accompanying medical expense incurred due to a job-related injury.
A single policy may cover risks in one or more of the above categories. For example, car insurance would typically cover both property risk (covering the risk of theft or damage to the car) and liability risk (covering legal claims from say, causing an accident). A homeowner 's insurance policy in the US typically includes property insurance covering damage to the home and the owner's belongings, liability insurance covering certain legal claims against the owner, and even a small amount of health insurance for medical expenses of guests who are injured on the owner's property.
Potential sources of risk that may give rise to claims are known as "perils ". Examples of perils might be fire, theft, earthquake, hurricane and many other potential risks. An insurance policy will set out in details which perils are covered by the policy and which are not.
Types of insurance companies
Insurance companies may be classified as
- Life insurance companies, who sell life insurance, annuities and pensions products.
- Non-life or general insurance companies, who sell other types of insurance.
In most countries, life and non-life insurers are subject to different regulations, tax and accounting rules. The main reason for the distinction between the two types of company is that life business is very long term in nature — coverage for life assurance or a pension can cover risks over many decades. By contrast, non-life insurance cover usually covers a shorter period, such as one year.
Insurance companies are 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 are insurance companies that sell policies to other insurance companies, allowing them to reduce their risks and protect themselves from very large losses. The reinsurance market is dominated by a few very large companies, with huge reserves.
There are also companies known as insurance consultants. Like a mortgage broker, these companies are paid a fee by the customer to shop around for the best insurance policy amongst many companies.
Similar to an insurance consultant, an insurance broker also shops around for the best insurance policy amongst many companies. However, with insurance brokers, the fee is usually paid in the form of commission from the insurer that is selected rather than directly from the client.
Life insurance and saving
Certain life insurance contracts accumulate cash values, which may be taken by the insured if the policy is surrendered or which may be borrowed against. Some policies, such as annuities and endowment policies, are financial instruments to accumulate or liquidate wealth when it is needed. See life insurance.
In many countries, such as the US and the UK, tax law provides that the interest on this cash value is not taxable under certain circumstances. This leads to widespread use of life insurance as a tax-efficient method of saving as well as protection in the event of early death.
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 the insured assumes the risk belongs to the insurer). To reduce their own financial exposure, insurance companies have contractual clauses that mitigate their obligation to provide coverage if the insured engages in some kind of behavior that grossly magnifies their risk of loss or liability.
For example, liability insurance providers do not provide coverage for liability arising from intentional torts committed by the insured. Even if a provider was irrational enough to try to provide such coverage, it is against the public policy of most countries to allow such insurance to exist, and thus it is usually illegal.
Lack of knowledge of policyholders
Insurance policies can be complex and some policyholders may not understand all the fees, regulation and coverages included in a policy. As a result, people could buy policies at unfavorable terms. In response to these issues, governments often make detailed regulations that set down minimum standards for policies and govern how they may be advertised and sold.
Many individuals purchase policies through an insurance broker. The broker can counsel the policyholder on which coverage to purchase and limitations of the policy. A broker generally holds contracts with many insurers which allows the broker to "shop" the market for the best rates and coverage possible.
Redlining was originally denial of insurance to any area because of the area.
Risk determines premium. Evaluation of risk by the insurer considers every available, quantifiable factor, including location, credit scores, gender, occupation, marital status, and education level. However, some people consider all or some of these factors to be "unfair" and sometimes make claims such as 'racism' about insurers' determination of premiums. So, for political reasons, governments may limit the factors that may be used.
A refutation to this is that the job of an insurance underwriter is to properly categorize a given risk as to the likelihood that the loss will occur. Any factor that causes a greater likelihood of loss should in theory, be charged a higher rate. This is a basic principle of insurance and must be followed for insurance companies or groups to operate properly, even for non-profit organizations. Thus, discrimination of potential insureds by legitimate factors is central to insurance. Therefore the only thing that can be considered legitimately "unfair" are practices that discriminate against a given group without actual factors that show that the group is a higher risk. So, eliminating real factors discriminates against other insureds by forcing them to bear part of the cost of the disallowed perceived factors.
Health insurance, that is coverage for individuals to protect them against medical costs, is a highly charged and emotional issue in the United States. In theory, it should work as any other insurance policy but the skyrocketing cost of health coverage has polarized the issue. Please see health insurance for a discussion of this category.
Glossary of terms, a guide to reading insurance industry financial statements and reports
- Combined ratio — (Incurred losses + incurred underwriting expenses) ÷ earned premiums — (or) loss ratio + expense ratio + dividend ratio. It is calculated by dividing the sum of incurred losses and expenses by earned premium. A lower number is better.
April 2005 - (Hearsay quote) Hank Greenberg told his board of directors that "you can't even spell 'insurance'" ().