From the point of view of the insurance company there are four general criteria for deciding whether to insure events or not. 1. there must be a larger number of similar objects so the financial outcome of insuring the pool of exposures is predictable. Therefore they can calculate a «fair» premium. 2. the losses have to be accidental and unintentional from the point of view of the insured. 3. the losses must be measurable, identifiable in location, time, and be definite. They also want the losses to cause economic hardship. That is, so the insured has an incentive to protect and preserve the property to minimize the probabilty that the losses occur. 4. the loss potential to the insurer must be non-catastrophic. It cannot put the insurance company in financial jeopardy.
Losses must be uncertain.
The rate and distribution of losses must be predictable: To set premiums (prices) insurers must be able to estimate them accurately. This is done using the Law of Large Numbers which states that: The larger the number of homogenous exposures considered, the more closely the losses reported will equal the underlying probability of loss. If the coverage is unique, the insured will pay a correspondingly higher premium. Lloyd’s of London often accepts unique coverages. (e.g., the insuring of Tina Turner’s legs and Jennifer Lopez’s buttocks)
The loss must be significant: The legal principle of De minimis dictates that trivial matters are not covered. Furthermore, rational insurance uses existing insurance when the transaction costs dictate that filing a claim is not rational. Actually, De minimis does not come into play here. The reality is that it costs too much to insure frequent and/or small losses. It is much more cost effective to not transfer small loss potential to insurance companies by taking the largest deductible that you can stand (given adequate price reduction). As for filing small claims, if the insurance company contractually should pay for it, you should file it. This is the difference between deciding before the contract the parameters and after following through.
The loss must not be catastrophic: If the insurer is insolvent, it will be unable to pay the insured. In the United States, there is a system of Guarantee Funds that run at the state level to reimburse insured people whose insurance companies have become insolvent. This program is run by the National Association of Insurance Commissioners (NAIC). In the United Kingdom, the Financial Services Authority (FSA), which regulates all insurance companies, has its own standards of solvency which must, by law, be adhered to. To avoid catastrophic depletion of their own capital, insurers almost universally purchase reinsurance to protect them against excessively large accumulations of risk in a single area, and to protect them against large-scale catastrophes.
Additionally, “speculative risks” like those incurred through gambling or through the purchase of company stocks are uninsurable.
Insurance Contract Principles
A property or liability insurance policy is a «personal contract,» a «conditional contract,» a «unilateral contract,» a «contract of adhesion,» a «contract of indemnity,» and a contract which requires that the person insured have an insurable interest at the time of the insured-against contingency.
Further: An Insurance Contract is one of Uberrima fides. This is a Latin phrase meaning «utmost good faith» (or translated literally, «most abundant faith»). It is the name of a legal doctrine which governs insurance contracts. This means that all parties to an insurance contract must deal in utmost good faith, making a full declaration of all material facts in the insurance proposal. Under utmost good faith contracts if there is a violation it is categorized as a material misrepresentation, a breach of a warranty, or a concealment. Insureds can also go after insurers for a breach of utmost good faith. Normal business contracts are «good faith contracts» and can result in contract enforcement, monetary damages or both. If the contract cannot be performed or is unconsionable, the contract can be set aside. This contrasts with the legal doctrine of caveat emptor (let the buyer beware). Caveat emptor does not come into play in insurance contracts. The buyer does have an obligation to read the contract and if is not understood to ask the sales agent to explain. It is best to get the explanations in writing.
Property and liability insurance policies cover persons and not property or operations. Although the terms «insured my house» or «insured my motorcycle» are used commonly, they are not technically correct. The contract between the insurer and the insured is a personal contract between an insuring entity and a person(s) based upon their financial, «insurable interest», in the object or liability being insured. In other words, the question of whether payment is due upon the occurrence of a contingency, and how such payment will be measured, depends upon economic loss suffered by the person(s). For example, if a person sells her home and gives a contract covering the home to the new owner and a loss occurs, the insurer will not pay the new owner since there is no privity of contract. The insurer will not pay the old owner because there is no insurable interest.
Property and liability insurance policies are said to be «conditional contracts» because the obligation of the insurer to perform is conditional upon an event happening. Compare this to entering into a contract to build a house. Both parties must perform. Build and payment. This is not conditional.
Only one party is legally bound to contractual obligations after the premium is paid to the insurer. Only the insurer has made a promise of future performance, and only the insurer can be sued for breach of contract. However, in order for an insured to collect, the insured must perform according to the contract. If the insured does not perform then the insurance company does not have to perform. This is mainly covered in a section called «Duties after a loss» found in insurance contracts.
Contract of Adhesion
Property and liability insurance policies are said to be «contracts of adhesion» because the insurer and insured parties are generally of unequal bargaining power where the insured party cannot negotiate the terms of the contract and must take the offer of the insurer as made. The contract can be modified by endorsing the contract using pre-approved language. It also must be noted that the language in insurance contracts are generally approved by state law. And for life insurance, if the language does not meet insurance code minimums, the minimum is automatically read into the contract. Importantly, the rule of law regarding «contracts of adhesion» is that any ambiguities are resolved against the WRITER of the contract. The writer of the contract most of the time is the insurance company. However, large companies can write their own «manuscript» policies and place them in a broker’s hands for bids. In this case ambiguities are construced against the writer — the insured in this case.
Contract of Indemnity
Property and liability insurance policies are said to be «contracts of indemnity» because the purpose of insurance is to indemnify the insured—that is, to make good a loss that the insured has suffered. The principle of indemnification is that the insured should not profit from the policy. This does not preclude that the insured will suffer some loss. In fact, many policies include a deductible which guarantees that the insured will pay part of each loss himself.
Insurable interest is one wherein economic loss would be suffered from an adverse occurrence to the person(s) insured.
A person can only collect in property casualty if the insured has insurable interest at the time of the loss. Many times a person can buy a valid contract but there is no insurable interest yet. An example is before buying a house you have to show up with a contract or a binder proving that the house is insured to receive the mortgage — thus, one may insure property where there is not insurable interest in anticipation of such. One can only collect at the time of loss if insurable interest then exists.
In life insurance, one only needs insurable interest at the time the policy is taken — no continuing insurable interest is required. Controversial areas include corporate-owned life insurance, investor-owned life insurance and viatical settlements.
An entity seeking to transfer risk (an individual, corporation, or association of any type) becomes the ‘insured’ party once risk is assumed by an ‘insurer’, the insuring party, by means of a contract, defined as an insurance ‘policy’. This legal contract sets out terms and conditions specifying the amount of coverage (compensation) to be rendered to the insured, by the insurer upon assumption of risk, in the event of a loss, and all the specific perils covered against (indemnified), for the term of the contract.
When insured parties experience a loss for a specified peril, the coverage entitles the policyholder to make a ‘claim’ against the insurer for the amount of loss as specified by the policy contract. The fee paid by the insured to the insurer for assuming the risk is called the ‘premium’. Insurance premiums from many clients are used to fund accounts set aside for later payment of claims—in theory for a relatively few claimants—and for overhead costs. So long as an insurer maintains adequate funds set aside for anticipated losses, the remaining margin becomes their profit.
Insurer’s Business Model
Profit = Earned Premium + Investment Income — Incurred Loss — Underwriting Expenses.
Insurers make money in two ways. Through underwriting, the process through which insurers select what risks to insure and decide how much premium to charge for accepting those risks and by investing the premiums they have collected from insureds.
The most difficult aspect of the insurance business is the underwriting of policies. Based on a wide assortment of data, insurers predict the likelihood that a claim will be made against their policies and price products accordingly. To this end, the industry uses actuarial science to quantify the risk they are willing to assume. Data is analyzed fairly accurately to project the rate of future claims based on a given risk. Actuarial science uses statistics and probability to analyze the risks associated with the range of perils covered, and these scientific principles are used to determine the insurers overall exposure. At the end of a given policy, the amount of premium collected minus the amount paid out in claims is the insurer’s underwriting profit.
An insurer’s underwriting performance is measured in their combined ratio. The loss ratio (incurred losses and loss-adjustment expenses divided by net earned premium) is added to the expense ratio (underwriting expenses divided by net premium written) to determine the company’s combined ratio. The combined ratio is a reflection of the company’s overall underwriting profitability. A combined ratio of less than 100 percent indicates profitability, while anything over 100 indicates a loss.
Insurance companies also earn investment profits on “float”. “Float” or available reserve is the amount of money, at-hand at any given moment, that an insurer has collected in insurance premium but has not been paid out in claims. Insurers start investing insurance premium as soon as it is collected and keeps earning interest on it until claims are paid out.
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 insurance industry insiders, most notably Hank Greenberg, do not believe that it is forever possible to sustain a profit from float without an underwriting profit as well, but this opinion is not universally held. Naturally, the “float” method is difficult to carry out in an economically depressed period. Bear markets do cause insurers to shift away from investments and to toughen up their underwriting standards. So a poor economy generally means high insurance premiums.
Insurers currently make the most money from their auto insurance line of business. Generally better statistics are available on auto losses and underwriting on this line of business has benefited greatly from advances in computing. Additionally, property losses in the US, due to natural catastrophes, have perpetuated this trend.