Insurance is the business of providing protection against financial aspects of risk, such as those to property, life, health and legal liability. It is one method of the overall concept known as risk management.
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 an enormous 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 analogous 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 on 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. The Talmud deals with several aspects of insuring goods. 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
There are a number of different types of insurance:
- 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, usually to make up for their loss of his or her income.
- 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
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, 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 councel 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.
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 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.
Some common complaints about private health insurance companies are discussed in the health insurance article.
- The history and future of the insurance business (http://samvak.tripod.com/pp147.html)