Gambling analogy

Insurance can be considered as a type of wager. The insurance company bets that you or your property will not suffer a loss, while you put money on the opposite outcome. The bet is the premium paid against the amount for which an insurance company can be held liable if an accident happens. For this reason, a number of religious groups avoid insurance and instead depend on support provided by their communities when disasters strike. This is a kind of "social insurance" In closed, supportive communities where others can be trusted to step in to rebuild lost property, this arrangement can work.

However, most societies could not effectively support this type of system, and the system will not work for large risks. For very large risks, Western insurance can also run into difficulties. This is the case when floods occur, war breaks out or earthquakes happen. In these cases a reinsurance comes in.

While insurance is analogous to gambling in terms of risk and reward, the main difference is in the motivation behind the process. This means in the case of insurance risk seeking versus risk avoidance, while in the case of gambling you assume risk that otherwise would not exist.

Risk management, the practice of appraising and controlling risk, has evolved as a discrete field of study and practice.

Principles of insurance

1) The rate of losses must be relatively predictable .

To be able to set premiums, insurers must be able to estimate risks. For this they use the Law of Large Numbers. The larger the number of homogenous exposures, the more closely the losses reported will equal the underlying probability of loss. If the coverage is unique, the insured will have to pay a higher premium. Lloyds of London often accepts unique coverages.

2) The loss must be significant

Trivial matters are not covered.

3) The loss must not be catastrophic

If the insurer is insolvent, it will be unable to pay. To avoid catastrophic depletion of their own capital, insurers use to purchase reinsurance. Speculative risks incurred through gambling or through purchase of shares are uninsurable. 

Contract Principles

A property or liability insurance policy is a "personal contract," and requires that the person insured have an insurable interest when it comes to the insured-against contingency.

Property and liability insurance policies cover persons, not property or operations. The contract between the insurer and the insured is a personal contract based on the damage a person might face and not based on the object as such. 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. 

Conditional Contract

Property and liability insurance policies are said to be "conditional contracts" because the obligation of the insurer to perform may be conditioned upon the insured satisfying certain conditions. 

Unilateral Contract

Only one party is legally bound to contractual obligations after the premium is paid. Only the insurer has made a promise of future performance, and only the insurer can be charged with breach of contract. 

Contract of Adhesion

Property and liability insurance policies are "contracts of adhesion" because the insurer and insured parties are 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 rule of law regarding "contracts of adhesion" is that any ambiguities resolve in favor of the insured. 

Contract of Indemnity

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

An insurance contract is only valid. if the insured has an insurable interest and stands to lose out if that subject is damaged. 

Indemnification

An entity seeking to transfer risk becomes the 'insured' party once risk is assumed by an 'insurer', by means of an insurance 'policy'. This contract sets out terms and conditions specifying the amount of coverage 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, for the term of the contract.

When insured parties experience a loss 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. 

How an insurance company makes money

They 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.

By investing the premiums they have collected from insured.

The most difficult aspect is the underwriting of polices. Based on a wide assortment of data, insurers predict the likelihood that a claim will be made and price products accordingly. At the end of the policy term, the amount of premium collected minus the amount paid out in claims is the insurer's underwriting profit.

Underwriting performance is measured in the combined ratio. Here the loss ratio (claim/premium) is added to the expense ratio (expense/premium) to determine the combined ratio. The later is a reflection of the overall underwriting profitability. A combined ratio of less than 100% indicates profitability, anything above 100% indicates a loss.

Underwriting profit is limited in most of the worldwide leading insurance companies. It is the money invested rather than underwriting which brings the profit.

Earning investment money in economically distressed times is difficult. So a poor economy generally means high insurance premiums.

Insurers currently make the most money from auto insurance. Statistics are available on auto losses and underwriting on this line of business has benefited greatly from advances in computing.

Determination of rate structures

The insurer uses actuarial science to quantify the risk they are willing to assume. Data is generated to approximate future claims, ordinarily with reasonable accuracy. Actuarial science uses statisitics and probability to analyze the risks associated with the range of perils covered, and these scientific principles are used by insurers, in conjunction with additional factors, to determine rate structures.

For example, many individuals purchase homeowner's insurance policies by signing a contract paying a premium to an insurance company. If a covered loss occurs, the insurer is obliged by the terms of the contract to honor the claim. For some policyholders, the amount of insurance benefits received from their insurer will greatly exceed the expense of premiums paid. Others may never make a claim or receive any benefit other than the peace of mind rendered by the security of an insurance policy. When averaged, the total claims expense paid by an insurer should be less than the total premiums paid by their policyholders, with the difference allocated to overhead and profit. 

Insurance history

Early methods of transferring or distributing risk go back to Chinese and Babylonian traders as long ago as the 3 rd and 2nd millenia BCE. Chinese merchants traveling treacherous rivers redistributed their wares across many vessels to limit the loss if any single capsized. The Babylonians developed a system. recorded in the famous Code of Hammurabi 1750 BCE and which was practiced by early Mediterranean sailing merchants. If a merchant received a loan to fund his shipment, he would pay the lender an additional sum in exchange for the lender's guarantee to cancel the loan should the shipment be stolen.

A thousand years later Rhodes islanders invented the concept of general average. Merchants whose goods were shipped together would pay a proportionally divided premium, used to reimburse any merchant for goods jettisoned during storm or sinkage.

Greeks and Romans introduced health and life insurance when they organized guilds called "benevolent societies" which cared for the families and funeral expenses of members upon death. Guilds in the Middle Ages served a similar purpose.

Before insurance was established in late 17th century, "friendly societies" existed in England, to which people donated money that could be used in case of emergency.

Separate insurance contracts were invented in Genoa in the 14th century. These contracts allowed a separation of insurance and investment roles that proved useful in marine insurance. Insurance became far more sophisticated in post-Renaissance Europe, and specialized varieties developed.

Toward the end of the 17th century, the growing importance of London as a center for trade led to rising demand for marine insurance. In the late 1680s, Mr. Edward Lloyd opened a coffee house, which became a popular haunt of ship owners, merchants, and ships’ captains, and thereby a reliable source of latest shipping news. It became the meeting place for parties wishing to insure cargoes and ships, and those willing to underwrite such ventures.

Today, Lloyds of London remains the leading market for marine and other specialist types of insurance, though it works rather differently than the more familiar kinds of insurance.

Insurance as we know it today can be traced to the Great Fire in London, which in 1666 destroyed 13,200 houses. It took some more years before in 1680 England's first fire insurance company was established.

Regulation

Most countries have their own regulations.

Some Types of insurance

Among the different types of insurance are:

Automobil Insurance

probably the most common form of insurance, which 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 insuance

protects individuals and companies against various financial risks. A business might eg 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.

The same insurance might also cover failure of a creditor to pay money it owes to the insured.

Health Insurance

covers medical bills due to sickness or accidents. It is a political issue in the US, which does not have socialized health coverage as most of Western Europe.

In theory, the market for health insurance provision should function similar to other insurance coverages, but skyrocketing costs of health coverage have disrupted markets worldwide.

Liability Insurance

covers legal claims against the insured. This cover is mostly in connection with businesses like consultant, doctor, lawyer etc. The protection offered by a liability insurance policy is two-fold: a legal defense in the event of a lawsuit, plus indemnification with respect to a settlement or court verdict.

Life Insurance

provides a cash benefit to a decedent's family or other designated beneficiary, and may specifically 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.

Total permanent disability insurance

provides benefits when a person is permanently disabled and can no longer work in their profession, often taken as an adjunct to life insurance.

Marine Insurance

Covered originally loss or damage of goods at sea, but includes nowadays also loss or damage of goods when transported by land. Marine insurance compensates the owner of merchandise for losses sustained from fire, shipwreck, etc., but excludes losses that can be recovered from the carrier.

Environmental Liability Insurance

protects the insured from bodily injury, property damage and cleanup costs as a result of the dispersal, release or escape of a pollutant.

Political risk insurance

can be taken out by businesses with operations in countries, where revolution or other political conditions may result in a loss.

Professional Indemnity Insurance

normally a mandatory requirement for professional practitioners such as Architects, Lawyers, Doctors and Accountants to provide insurance cover against potential negligence claims. Non licensed professionals may also purchase malpractice insurance, commonly called Errors and Omissions Insurance, which covers a service provider for claims made against them that arise out of the performance of specified professional services. For instance, a web site designer can obtain E&O insurance to cover claims by third parties that arise out of negligent performance of web site development services.

Property Insurance

provides protection against risks to property, such as fire, theft or weather damage.

Travel Insurance

taken by those who travel abroad, covering losses such as medical expenses, lost of personal belongings, travel delay, personal liabilities etc.

Workers compensation insurance

replaces all or part of a worker's wages lost and accompanying medical expense incurred due to a job-related injury.

Types of insurance companies

Basically we know Life insurance companies, Non-life or general insurance companies and Reinsurance companies,

Besides there are also other forms.

Captive Insurance is an in-house self-insurance vehicle. Captives may take the form of a "pure" entity (a 100% subsidiary), a "mutual" captive (which insures the collective risks of industry members); and of an "association" captive, which self-insures individual risks of the members of a professional, commercial or industrial association.

Captives represent commercial, economic and often tax advantages to their sponsors due to the reductions on costs they help create, the ease for insurance risk management and the flexibility for cash flows they generate. Additionally, they may provide coverage of risks which are neither available nor offered in the traditional insurance market at reasonable prices.

The types of risk that a captive can underwrite include property damage, public and products liability, professional indemnity, employee benefits, employers liability, motor and medical aid expenses. The captive's exposure to such risks may be limited by the use of reinsurance.

Size of global insurance industry

Global insurance premiums reached in 04 $3.3 trillion. The average growth in the last few years has been for life and non life in the range of 8% yearly.

With premium income of $1,22trillion in 2004, North America was the most important region, followed by the EU $1,20tn and Japan $492bn. US and Japan alone accounted in 2004 for ca 50% of world insurance, much higher than their 7% global population share. Emerging markets over 85% of the world’s population generated only 10% of premiums.

Insurance Patents

The development of new risk coverage has speeded up in recent years. This is due to the fact that new insurance products can now be protected in the developed world by a business method patent. This may also lead to more rapid introductions of new insurance products as insurance companies will invest more in new product development if they can be assured that their patents will keep those products from being copied.

Many independent inventors are in favor of patenting new insurance products since it gives them protection from big companies when they bring their new insurance products to market. Independent inventors account for 70% of the new U.S. patent applications in this area.

Controversies

By creating a "security blanket" for its insured, an insurance company may find that its insured may not be as risk-averse as they should be, known as moral hazards. To reduce their own financial exposure, insurance companies have contractual clauses that mitigate their obligation to provide coverage if the insured engages in behavior that grossly magnifies their risk of loss or liability.

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