Transferring Losses
The concept of risk is the reason insurance exists. You might go an entire year with no auto accidents, but a single collision could create $50,000 or more in property damage and liability. Risk is part of life, and even spending large amounts of money can’t eliminate it completely.
To fully eliminate auto-related injuries, you’d have to eliminate automobiles. Since that isn’t realistic, an effective response to risk usually combines two approaches:
- Efforts to reduce the risk
- Insurance to cover the risk that remains
In exchange for a premium, the insurer agrees to pay a claim if a specified contingency occurs (for example, property damage, theft, or liability). Insurers can offer this protection because they pool risk across a large group of similarly situated individuals, called exposure units.
With a large pool, probability helps make overall results more predictable. For example, suppose 100,000 individuals each independently face a .5% risk of loss in a year. On average, 500 people will have losses. If each of the 100,000 people pays a premium of $1,000, the insurer collects $100 million total. That would be enough to pay $200,000 to each person who has a loss (assuming 500 losses).
In practice, insurers also build premiums to cover:
- Administrative costs
- Reserves
- Profit margins
Insurance relies on a statistical idea called the Law of Large Numbers. This law says that as the number of exposure units increases, actual results tend to get closer to expected results. In other words, larger groups make outcomes more predictable.
For instance, with a pool of 100,000 people who each face a .5% risk, the Law of Large Numbers implies that the number of losses will cluster tightly around the expected value (about 500). In this example, more than about 570 losses in the same period would occur only about 1 time in 1,000; 500 or more, the expected number, happens about half the time.
Insurance is also a business. It only works for companies that can stay financially strong while paying claims. Insurance helps you manage risk by protecting you from events that could seriously harm your financial future. The Law of Large Numbers helps insurers by making the total claims they pay from year to year predictable with reasonable accuracy.
A coin-flip example shows why sample size matters. When you flip a coin, the probability of heads is 50% and the probability of tails is 50%. But if you flip a coin 10 times and it lands on heads 9 times, does that mean the probability was wrong?
No. With a small sample (like 10 flips), actual results can vary a lot from what you’d expect. If you flipped the coin 10 million times, the results would be extremely close to 50% heads and 50% tails.
Even though predictability is essential to insurance, some perils are difficult to predict because they don’t produce stable patterns. In a hurricane, airplane crash, or epidemic, many losses can happen at the same time. Insurers manage these risks in several ways:
- Spreading risk across many individuals
- Spreading risk across time by building reserves in good years to handle heavier claims in bad years
- Using reinsurance, catastrophe bonds, or government programs such as the National Flood Insurance Program (NFIP) and the Terrorism Risk Insurance Act (TRIA)
- Diversifying across lines of insurance (for example, selling both health insurance and homeowners’ insurance)
Another basic rule of insurance is that before someone can benefit from insurance, they must face the possibility of economic loss if a claim occurs against the life or property being insured. This requirement is called insurable interest.
Insurable interest commonly arises in these situations:
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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.
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Insurable interest exists in the life of an immediate family member or marital partner (close kinship). Insurable interest also exists if there is a financial relationship (business partner, key person, or debtor).
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A person has an insurable interest in property when its damage or destruction would cause that person a financial loss. The owner of property has one, and so does a lender whose loan the property secures, such as a bank holding the mortgage on a house.
The timing differs by line. 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 the time of claim, even if the insurable interest no longer exists. With property insurance, the insurable interest must exist at the time of the loss (and in some states when the policy takes effect as well).
Not every risk can be transferred through insurance. Insurable risks have characteristics that make losses reasonably predictable, so insurers can 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. Uncertainty about what will happen to an exposure unit creates the need for insurance. If a future loss is certain, it isn’t insurable.
With life insurance, the uncertainty isn’t whether an individual will die, but when the individual will die and what financial obligations will remain. With property and casualty insurance, the uncertainty is whether a loss such as fire, theft, or collision will occur.
2) Large number of exposure units
Insurance companies can’t predict who will die when. However, by using data from a large number of people, they can predict with reasonable accuracy how many people in a population are likely to die during a certain period of time. The larger the group, the more accurately the insurer can predict losses for the group.
This is where the Law of Large Numbers supports premium setting: it helps insurers estimate expected claims so they can charge premiums that allow them to pay claims and maintain financial strength.
3) Loss must pose an economic hardship
If the potential loss doesn’t justify the premium and the insurer’s underwriting expenses, the risk isn’t insurable.
4) Loss must be ascertainable
The insurer must be able to measure the loss.
- 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.
- With property insurance, the loss is measured by the reduction in property value or the cost to repair or replace the damaged property.
5) Loss must be accidental and unintentional
Intentional acts or predictable events aren’t insurable. Insurance covers unforeseen and unplanned occurrences.
6) Loss must not be catastrophic to the insurer
The loss must not affect a large number of exposure units simultaneously. Catastrophic losses (such as war or widespread natural disasters) are typically excluded or managed through reinsurance.
Perils and Hazards
Perils and hazards are closely tied to risk.
A peril is the specific cause of a loss - the event being insured against. With life insurance, the peril is death. With property insurance, the peril may be fire, theft, or collision.
A hazard is a condition or factor that increases the chance that a peril will occur (or increases the severity of the loss). For example, faulty wiring is a hazard that increases the likelihood of a fire.
When someone applies for insurance, the insurer considers the hazards the applicant may face and how those hazards relate to the peril being insured against. There are 3 types of hazards insurers focus on:
- Physical
- Moral
- Morale
In property insurance, physical hazards are material, structural or operational features of the property or business that create or increase the chance of loss, such as faulty wiring, frame construction, a hazardous use of the building and a long distance to the nearest fire hydrant or fire station. In life and health insurance, physical hazards include factors such as a person’s weight, medical history, and occupation. A moral hazard involves dishonesty, such as lying about medical history, occupation, or hobbies, or engaging in fraud (for example, staging an accident). Morale hazards are more subjective and involve carelessness or indifference due to having insurance coverage, such as leaving doors unlocked because the property is insured.
Types of perils
A property policy states the perils it covers in one of two ways.
Under named perils coverage, the policy lists the causes of loss it covers, and only a loss caused by one of the listed perils is covered. The insured generally must show that the loss was caused by a listed peril.
Under open perils coverage, the policy covers every cause of direct physical loss unless the policy excludes it. Once the insured shows a direct physical loss to covered property, the insurer generally must show that an exclusion applies.
Lesson Summary
Insurance operates by pooling funds from many individuals facing similar risks. In exchange for a premium, the insurer agrees to pay for covered losses when specified events occur.
Key concepts in insurance are:
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The Law of Large Numbers forms the statistical basis for insurance operations by enabling companies to predict claims with reasonable accuracy by pooling risks across a large group.
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Insurable interest is needed for a person to benefit from insurance, with requirements including having a financial stake in the insured event.
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Perils are the causes of losses, while hazards are factors promoting these losses, with insurers considering physical, moral, and morale hazards in assessing risks.
Insurance helps manage financial risk for individuals, while insurers rely on pooling and statistical predictability to remain financially viable and pay claims.