General Insurance Concepts

Insurance is a social device designed to transfer the risk of economic loss to a common pool of funds contributed by many people sharing the same risk.

Property and Casualty insurance policies are contractual agreements between the insurance company (the insurer) and the policy owner (the insured) designed to indemnify the insured of financial loss upon occurrence of a specified event (fire, auto accident, theft, etc.) provided a stipulated consideration (the premium) has been met.  

Insurance contracts are unilateral, in that only one party to the contract makes an enforceable promise (the insurer). Insurance contracts are also aleatory, in that the outcome depends on chance and the consideration exchanged may not be equal.

Risk is commonly defined as an exposure to adversity or danger. In the insurance business, risk is the possibility of financial loss. Risk is the basic issue with which insurance deals; it is why insurance exists. There are two types of risk, pure and speculative.

Pure risk involves only the possibility of loss and can be managed through insurance. The purpose of insurance is to indemnify or to restore the insured to his/her original financial position. Insurance is not designed to provide a person with the opportunity of gain or profit.

Speculative risk includes the possibility of gain. Gambling and investing in the stock market are good examples. You may lose money, but you may also come out ahead. Speculative risk is not insurable.

Risk management is how one deals with the possibility of financial loss. There are five ways to manage risk:

1. Avoid
2. Reduce
3. Retain
4. Share
5. Transfer
   
   

The first method is to avoid risk. For example, a person might avoid the risk of wrecking a car by not driving.

Risk may be reduced by examining one’s exposures and eliminating them. For example, a person reduces the risk of a home owners claim by removing a tree with a rotted root system that may fall on the house.

A risk is retained when a person decides to assume financial responsibility for certain events; examples of risk retention include self insuring and deductibles. A deductible is common to most property insurance policies. It is the initial amount of a covered loss for which the insured is responsible. For example, if an insured suffered a $5,000 loss and his/her policy included a $500 deductible, he/she would be responsible for the initial $500 and the policy would pay the remaining $4500. A deductible is a common form of risk retention. It allows insurers to reduce the cost of coverage since the insured is assuming a portion of the risk.

A business owner taking on a partner is an example of risk sharing.

The final method of managing risk is to transfer the risk to another party. For many risks, the best way to transfer them is through insurance. Risk transfer, simply put, is to place the burden of possible economic loss on someone else. When insurance is purchased, a large, uncertain loss is exchanged for a small, certain loss, the premium. Insurance companies exist for this basic purpose; insurance companies, by definition, are the only organizations that have the authority to assume one’s risk of financial loss.

The concept of risk is why insurance exists. An insured may have absolutely no medical expenses in a good year, but if he/she is hit by a bus, they could easily be over $500,000. We cannot eliminate risk from life, even at extraordinary expense.

The only way to eliminate auto-related injuries is to eliminate automobiles. Thus, the effective response to risk combines two elements: efforts to lessen the risk, and the purchase of insurance against the risk that remains.

In exchange for a premium, the insurer will pay a claim should a specified contingency, such as death or medical bills arise. The insurer is able to offer such protection against financial loss by pooling the risks from a large group of similarly situated individuals (exposure units). With a large pool, the laws of probability assure that only a small fraction of the insured population will die or

be hospitalized in a year. If, for example, each of 100,000 individuals independently faces a .5 percent risk in a year, on average 500 will have losses. If each of the 100,000 people paid a premium of $1,000, the insurance company would collect a total of $100 million, enough to pay $200,000 to anyone who had a loss. But what would happen if 550 people had losses? The answer, fortunately, is that such an outcome is exceptionally unlikely. Insurance works through the

statistical concept of the Law of Large Numbers. This law assures that when a large number of people face a low-probability event, the proportion experiencing the event will be close to the expected proportion. For instance, with a pool of 100,000 people who each face a .5 percent risk, the law of large numbers dictates that 550 people or more will have losses only one time in 1,000.

Insurance is a business. But it is only a business for those companies who are able to maintain their financial strength while paying out claims. While insurance helps you manage risk by protecting against things that would significantly impact your financial future if they occurred, the law of large numbers helps insurance companies by making predictable, with reasonable accuracy, the claims it will pay from year to year.

Note: The larger the number of exposure units in the group, the more accurately the insurance company can predict future losses of the group as a whole. It is NOT possible to predict the probability of loss for each individual exposure unit in the group.

When you flip a coin, the probability that the coin will land on heads is 50% and the probability it will land on tails is 50%. However, let's say we flipped a coin 10 times, and it lands on heads 9 of those times. Does this mean the calculated probability was wrong?

No. In a small sample such as 10 coin tosses, the actual results may vary considerably from predicted results. However, if we flipped the coin 10 million times (a large number of times) the calculated probability of 50% heads and 50% tails would be extremely accurate.

Although the ability to predict future losses with some degree of accuracy is critical to the concept of insurance, certain types of perils are unpredictable. Such perils, when they cause losses, do not establish a pattern of predictability that can be used for future predictions of anticipated loss. In a hurricane, airplane crash, or epidemic, many may suffer at the same time. Insurance companies spread such risks not only across individuals but also across good years and bad, building up

reserves in the good years to deal with heavier claims in bad ones. For further protection they also diversify across lines, selling health insurance as well as homeowners' insurance, for example.

Another basic rule governing insurance states that before an individual can benefit from insurance, he/she must face the possibility of economic loss in the event of a claim against the life or property being insured. This requirement is known as insurable interest.

Insurers will recognize 3 situations that constitute insurable interest:

1. An individual always has an insurable interest in his/her own life. Therefore, anyone (who is legally capable of doing so) may apply for an insurance policy on themselves.
2. Insurable interest exists on the life of an immediate family member or marital partner (close kinship).
3. Insurable interest also exists if there is a financial relationship (business partner, key person, or debtor).

Insurable interest need only exist at time of application with life insurance. Once the policy has been issued the insurer must pay the death benefit at time of claim even if the insurable interest no longer exists.

Certain risks may not be transferred through insurance; insurable risks have certain characteristics that make the rate of loss fairly predictable, allowing insurers to adequately prepare for the losses that do occur. For a risk to be acceptable to a conventional insurance company, it must meet the following criteria:

1) Loss Must Be Uncertain

The purpose of insurance is to offset the financial loss of a covered event. Not knowing what is going to happen to the individual exposure unit creates the need for insurance. If a future loss is certain, it is not insurable.

With life insurance, the uncertainty rests not with whether an individual will die, but rather with when that individual will die and what financial obligations will be left behind when death does occur.

2) Large Numbers of Exposure Units

Insurance companies cannot predict who will die when, but by using data about a large number of people, they can predict with reasonable accuracy how many people in a given population are likely to die during a certain period of time (the larger the group, the more accurately the insurance company will be able to predict losses of the group). And thus, the law of large numbers aids insurance companies in determining appropriate premium charges to ensure they can maintain financial strength while paying out claims.

3) Loss Must Pose an Economic Hardship

If the potential loss does not justify the outlay of premium and the underwriting expenses to the insurance company, the risk is not insurable.

4) Loss Must Be Ascertainable

With life insurance, monetary value is placed on the insured’s ability to earn an income or on the needs of his/her survivors. With health insurance, economic loss is measured by lost wages or by actual medical expenses incurred.

Perils and hazards

Perils and hazards are related to the concept of risk. A peril is the specific cause of a loss and is the event being insured against. With life insurance, the peril being insured against is death. A hazard is a condition or factor that promotes the peril. Hang gliding, for example, is a hazard that promotes the peril of death.

When a person applies for life or health insurance, the insurer looks at the hazards that the applicant may encounter and how they relate to the peril being insured against. There are three types of hazards with which insurers are concerned:

• Physical
• Moral
• Morale
  
  

Physical hazards include factors such as a person's weight, medical history, and occupation. A moral hazard is a dishonest applicant, one who lies about his/her medical history, occupation or hobbies. Morale hazards are more subjective and include such things as road rage, the tendency to drink alcohol to excess, or use drugs, which can promote the risk of health problems or premature death.