Insurance can be complicated.  In this article we will look at a few definitions of insurance as well as a few common characteristics regarding insurance policies.

Insurance is defined as a form of risk management.  It is used to hedge against the risk.  Risk means the amount of loss insurance may have to cover.  Insurance is also a transfer of equitable risk of loss.  This loss is defined as a loss from one person or place to another.  Insurance charges a premium based on the risk the insured poses to the company.

Insurer, means the company offering the insurance to the insured.  The insurance company is going to assess the risk of the insured and determine the insurance rate to charge or the premium.  The premium is also dependent on the amount of insurance coverage needed.

Risk management is what the insurance company imposes in order to assess and control the risk of the insured.

Principles of insurance

There are seven common characteristics regarding insurance.

1. A large number of homogeneous exposure units.  Insurance policies have different classes for individual members.  As an example we will use auto insurance.  Auto insurance covers roughly 175 million vehicles in the United States as of 2004.  The large number of homogeneous exposure units, in other words how many vehicles are covered, allows the insurers to benefit from a law.  This law is “of large numbers,” meaning the number of exposure units that increase will affect the results.  There are some exceptions to this rule.  Lloyd’s of London is a company typically able to avoid or offer exception to the “law of large numbers.”  Lloyds of London will insure the life or health of actors, actresses, and sports figures.  Satellite Launch is a company that offers infrequent coverage.  Some commercial property policies may be covered where there are no homogeneous exposure units. 
2. Definite Loss.  An insurance policy states, “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.”  This means that any event that a loss has occurred should have these principle parts answered.  If a death occurs of the insured the company should know when that took place, where it took place, and the reason for the death.  If this information is not known or given the insurance company can refuse the insurance.  The specific type of loss is also important.  Certain deaths may not be included in the insurance policy.  Typically things such as fire, automobile accidents, and work injuries are going to be covered.  Occupational disease where a prolonged exposure to the element where there is no specific time, place, or cause may not be covered.  The insurance company asks for this information to be very clear and verified. 
3. Accidental Loss.  In this case the event that occurs in which a claim will be filed needs to be outside the control of the beneficiary.  This means that the loss such as death, a house fire or other example should be an accident in which the person claiming on the insurance had no control of the situation.  The loss is to be “pure.”  Events that typically are considered in your control or at least suspect will not be covered.
4. Large Loss. The insured will determine what a large loss is.  The insured will be subject to insurance premiums that will cover the expected loss.  It will also cover the cost of the issued policy and administration, adjusting any losses, and supplying the capital in order to be fully covered.  The small losses will be tallied up to determine the overall large loss.  If the small loss will cost more for protection then there is no value in buying the protection.
5. Affordable Premium. The affordable premium is basically making the insurance affordable to the insured.  If the insurance is not cost effective because the large loss requires a larger premium then the insured or potential insured will not buy the coverage.  The premium also cannot be so large that there is not a significant loss to the insurer.  In other words the insurance would have the form of being insurance, but would not offer the benefits.
6. Calculable Loss. The calculable loss says there are two things you must consider in order to determine the numerical value.  Probability of loss and attendant cost must be calculated on the insurance policy.  Probability loss states that the actual cost is dependent on what a reasonable person may have in their possession and that there is a proof of this loss.  In other words for this policy to pay out the person must have documentation of the insurance policy as well as documentation regarding the claim that would be filed.
7. Limited risk of catastrophically large losses. The definition of this is that an insurance company must be able to afford the insurance they may have to pay out.  In other words if a catastrophe occurs in which the policyholders of one insurance company must make a claim the insurer must be able to afford those claims without becoming constrained.  The factors are not to be related to the insured in regards to making the policy.  Most insurance companies like to limit their loss exposure.  This means that they will allow 5 percent to be lost in a single event.  If an insurance company finds that the policy holder will produce a rather large claim then the insurance company may find they are unwilling to insure more policy holders.  An example of this would be an earthquake or hurricane.  If the policy is in an area of high probability for loss they are going to be unwilling to insure the policy holder, without it being underwritten specifically for that type of loss.  The policy holder would have to have hurricane, earthquake or even wind insurance to cover the natural event.  Without this specific clause in the insurance the company would not have to pay out if an event did occur.

Indemnification

Indemnity means that you make something whole again.  As it pertains to insurance the insurance company would be required to pay out to the policy holder in order to fix a problem that occurred and that is covered by the policy.  There are two types of contracts.  Indemnity and pay on behalf are the two policies.  There is little difference between the two in actuallity.

Indemnity states that a policy will never pay a claim until the insurance has paid for the cost to the third party.  For an example if you have a visitor and then fall on your floor, then they sue you and win, you must pay the person who sued you before the insurance will pay you.  If you have to pay out 20,000 dollars to the injured person, you must do so before the insurance company pays you that amount.

With the pay on behalf policy the insurance company will pay for the damage done on your behalf.  Let’s look at the above example again.  If the court awards 20,000 dollars to the injured party the insurance company would cut the check for that amount rather than you paying it out of your pocket.

Anyone person or corporation that becomes the insured will be asking the insurer or insuring party to take on the risk.  In order to have an insurance policy you must have a contract with the insured and insurer.  This contract will ask the insurance company to protect the insurer from any risk.  There are a minimum of points that are included in the policy.  The parties, i.e. the insurer, insured and beneficiaries, the premium, length of coverage, loss event that is covered, amount of coverage and any exclusions must be listed in the contract.  Anything that is included in the contract is indemnified and therefore protected against the losses covered in the policy.

If the insured person suffers a loss for a specific reason, as long as it is covered in the policy they are able to make a claim against the insurer.  This claim states that the insurer must pay for the loss as specified in the policy.  The fee or premium paid to the company is asking the insurer to assume that risk.  Whenever a premium is paid the amount goes into a fund account reserved for claims the insurer may have to pay.  As long as the insurer maintains the funds for any anticipated losses they are allowed to take the remaining margin as profit.

Insurer’s business model

Profit = earned premium + investment income - incurred loss - underwriting expenses.

The insurance companies are in the business of making money.  They will try to make this money in two ways.  First they will do so through underwriting and second by investments.  Underwriting is the process the insurer uses to select the risks to the insured and to decide how much they will charge for those risks.  The investment is where they take the premiums they collect from the insured and place it in a fund account to increase their holdings.

Underwriting is the most difficult part of an insurance business.  They must use several pieces of data in order to assess the risk of a particular client.  This data will predict the likelihood of an insured individual filing a claim.  This process will state their policies and price for the products.  Actuarial science is used in order to quantify the risk of any person looking for insurance.  It will assume certain things and use these assumptions to charge a premium.  The data is usually accurate.  In actuarial science statistics and probability are used.  These two mathematical procedures will look at the chances a claim will be filed and under what conditions.  At the end of a policy the amount of premium collected and the gains from investments minus any claims paid out will offer the profits from the underwriting portion of a contract.  Insurers will make more money if they don’t have to pay out for a claim on a policy.  Therefore the profit when you add the premiums paid and the investments are much better and what they really hope to gain by assessing risk.

To measure the performance of underwriting the companies look at the combined ratio.  In other words the loss ratio is added to the expense ratio in order to find the combined ratio.  The combined ratio is a reflection on the company’s profits.  If the combined ratio is less than 100 percent then they have made a profit.  If it is over 100 they will have an underwriting loss.

Investment companies are important as well.  The profits earned from investments are called a float.  A float means the available reserve that they have at any moment in time.  This money comes from the premiums they have collected, but has not been paid towards claims.  The insurers will start to invest the premium money as soon as it is paid and it will earn interest as long as it is not paid out on a claim.

The United States has underwriting loss of property and casualty insurance at a little over 142.3 billion dollars for the last five years.  In other words since 2003 they were at a loss because of the amount of claims they had to pay out.  They also had an overall profit in 2003 of 68.4 billion dollars from the float or investment portion.  Hank Greenberg, an insurance insider doesn’t believe you can have a sustainable profit from the float unless you also have profit in the underwriting as well.  This opinion is not universally held though.  When the economy is suffering it can be hard to keep the float at a profit, however if the insurance companies change their underwriting policies so that they are more restrictive they can make it through the tough stage.

Property and casualty insurance companies tend to make more money than other insurance companies like the automobile industry.  There are better statistics for the auto losses and underwriting which means they have benefited from computer technology in order to gain these better numbers for their consumers.  Property loss as a result of nature have created more losses in the US not helping the current trend.

Claims and loss handling are part of insurance as well.  They are the material part.  Insurers try to find a balance between customer satisfaction, administration fees, and claims overpayment leakages.  Fraudulent insurance practices are also part of the balancing issue because it is hard to find the businesses or individuals actually doing the fraudulent acts.  Fraud constitutes heavy losses for the insurance business.

Insurance was not always available.  In fact insurance only cropped up when economics began.  In other words when money and natural economics hit the human race the need for some type of insurance began.  Of course the first form of insurance was simplistic to what we have now and is considered to be ancient.  With economy and community insurance must help the people.  In olden days when a house burned down the community would rally to help the folks who lost their home in rebuilding and offering labor.  Now if a house burns down the insurance company will help to build a new one with money given.  Going back to our older example if the neighbor was unwilling to help then they would not receive help if they needed it later on.  It was the type of insurance that didn’t involve money as much as it involved treating others correctly and how you would want to be treated.  This type of insurance has survived in some countries, but it other countries it is a financial instrument.  It just depends on the advancement of the country.

For insurance in today’s world you have insurance as a modern money economy.  This type of insurance began with the Chinese and Babylonian traders in the 3rd and 2nd millennia BC.  The Chinese merchants who had to travel along dangerous paths such as rivers because they were selling items to others needed a way to take a loss without compromising their business.  The Babylonian system was recorded by the Code of Hammurabi in 1750 BC.  It was also practiced in the Mediterranean by the merchants who sailed.  If a merchant needed a loan for his shipment he would pay the lender a sum or premium in exchange for that help.  It was basically a lender guarantee in case the shipment was stolen.

Achaemenian monarchs made the insurance official by registering it with the notary offices of the government.  Norouz was the site of a traditional insurance festival performed each year in honor of the official registering of the practice.  Many ethnic groups participated as well as offering presents to the Monarch of the time.  The special gift was always offered during a ceremony of special significance.  If the gift was more than 10,000 Derrik, gold, it was given in a special office.  By registering the gift the person could be helped out if needed.

For example if the person offering such a gift was in trouble then the monarch or court would be able to help them.  Jahez was a writer on Ancient Iran.  This is what he said,"[W]henever 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, he or she would receive an amount of twice as much."

Those in Rhodes a little over a thousand years later came up with their own system for insurance.  This was called general average.  It meant that those who shipped together would get a divided premium that was proportionate and fair.  If the ship was lost and the goods with it then they would be reimbursed for the loss.

Greeks and Romans also had their own type of insurance.  They first created health and life insurance during 600 AD.  Guilds were organized to offer care for families as well as pay for any funeral costs upon death.  You had to be a member in order to receive the benefits.  The middle ages also had a similar set up.  Talmud deals were offered for goods.  England also had their own style of insurance before the 17th century.  Individuals would donate money to a general account for the use in an emergency.

In the 14th century in Genoa insurance contracts were created.  These contracts stated that the insurance would not be placed in with loans or other contracts.  The insurance contracts allowed a separation for investments as well as a role for marine insurance.  After Renaissance Europe insurance became even more sophisticated and specialized.

London grew in important during the 17th century and made it a huge centre for trade.  This meant that marine insurance was very important and thus the Lloyd’s of London you are familiar with today began.  In 1680 Mr. Edward Lloyd decided to open a coffee house.  It was a very hot spot for merchants, ship owners, and captains.  Since it was so important it became a meeting place for parties trying to insure their goods and ships.

The Great Fire of London in 1666 leads to the current insurance we see today.  There were 13,200 houses caught in that fire.  The disaster led Nicholas Barbon to open up an office in order to sell insurance.  In 1680 his establishment was the first fire insurance company to be created.

In the United States the first insurance company was started in Charles Town or Charleston South Carolina.  It began in 1732.  Benjamin Franklin was one of the leading individuals to propel the insurance industry for fire and other disasters.  It was the start of perpetual insurance.  In 1752 Benjamin Franklin started the Contributionship for the Insurance of Houses from Loss by Fire.  This company made contributions towards fire prevention by warning about different fire hazards such as wooden houses.  The US formed a regulation of the insurance companies.  It is considered to be Balkanized as the primary concern for insurance is at the state level rather than the national.  Now we have international and national insurance markets that are centralized.  Part of this centralization is the National Insurance Commissioners’ Organization.  Lastly for insurance in recent years there was a dual state and federal regulation system in place.  This helps protect the consumers.  It is akin to the state bank and national bank system.

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