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Basic Principles

At its core, insurance is a method for individuals to share risk: each policyholder contributes a premium, and these premiums form a pool of funds from which losses can be paid.

Economic and Political Perspective

In an capitalist economy, Insurance is a business (a private commercial enterprise of explicit and voluntary commitment). The risks covered, amounts due, and procedural matters, are documented as an insurance policy, which is a legally enforceable contract between insurer and insured.

In a communal economy, insurance can be provided through an arrangement among individuals to take care of one another should one suffer a loss. Such arrangements tend to be informal and undocumented.

In a statist economy, insurance is provided through government programs (ongoing or special case) that are funded through taxes. The nature and conditions of coverage, as well as its amount, are generally arbitrary and undocumented.

In the current US economy, the implementation is mixed: in most cases, it is a capitalist enterprise, with some government intrusion and precipitating regulation; in some cases, insurance is handled in a purely statist manner (government aid programs funded with taxpayer dollars). Instances of communal practice are not unheard of, but are not extensively documented.

Since this research is being conducted in the context of understanding insurance as a business, the material that follows will focus largely on the capitalist incarnation, albeit with elements of statist intrusion.

Policies

An insurance policy is a contract that documents the terms to which the insured and the insurer agree. While the insurance policy is typically a written contract, it may be enforceable as a verbal contract (per common law, a writ is necessary only in certain instances, such as real estate transactions).

Policy Content

Typically, the contract includes:

Standards and practices in the insurance industry, or the laws in a given state pertaining to insurance, may require the specific documentation of certain facts, and it may allow certain others to be elided.

Policy Structure

The contract may be written in any fashion, but a fairly standard pattern has evolved over time:

Legal Aspects of Insurance Policies

An insurance policy satisfies the common law requirements of a legal contract, in that it imparts specific duties on each party in exchange for duties on the part of the other (consideration) according to the terms set out in a writ (specificity).

Insofar as business contracts are concerned, an insurance policy has the following qualities:

Another notable legal feature is that an insurance contract is deemed incontestable after the contract has been in force for two years - specifically the insurer bears the responsibility of investigating the insured to identify the risk, and can no longer void the policy for things they may discover later. This typically applies only to life insurance, as most other contracts have a term of less than two years.

Generally, a policy is valid on the day it is executed, for the term it specifies. Unless the conditions of the contract specifically state otherwise:

An insurer generally cannot "cancel" a policy (unless the terms of the policy specifically permit this) - however, an insurer can decline to renew a policy at its expiration. It is not uncommon for an insured to mistake the latter for the former, but there is a distinct difference between cancellation and non-renewal.

Premiums

Premiums are payments from the insured to the insurer to "purchase" a policy. The premium may be paid all at once, or it may be paid over time, according to the terms of a policy.

Also, unless the policy's terms state otherwise, the payment of premium is not prerequisite to coverage (the contract's start date is effective, even if the premium has not been paid).

From the insurer's perspective, premium payments are their source of revenue for providing an insurance product. Unless specified otherwise by the terms of the contract, they collect no other monies from the insured.

From the insured's perspective, the premium is the cost of the policy. The money paid out is not recoverable or refundable unless the insurer violates the terms of the policy.

Indemnity

The term "indemnity" applies to the payment made to policyholders in the event of a loss. This is the "product" that policyholders are buying in exchange for their premiums. Indemnity is often limited in insurance policies: there is a specific limit to coverage above which the policy will not pay.

In a broad sense, indemnity can be made in several ways: it may involve a cash payment to compensate for a loss, covering the cost of repair to a damaged item, replacing a damaged or stolen item.

Caveat Emptor: If an insurance policy is vague on the method of indemnification, it is the insurer's choice. The insured may take their complaint to court if they disagree, but the courts tend to side with the insurance companies (except in cases where the "indemnification" chosen by the insurer was woefully inadequate).

Named Insured

Also worth noting: an insurance policy may indemnify individuals other than the person who purchased the policy. It is often the case a person buys a policy to indemnify himself, but other beneficiaries may be named in the contract ("named insured"). Sometimes, the policyholder is neither a beneficiary nor insured at all (when an employer provides coverage for employees).

Also, third-parties may be indemnified by a policy, though this is by proxy: their loss is covered only because they would otherwise have grounds to sue a person who is actually insured - so while restitution is made to a third party, the policy actually protects the assets of a named insured against lawsuits.

It is also worth noting that a named insured who has not signed the policy is not bound by its terms. For example, a person living in a house may be named on the homeowner's policy, but if they are injured, they are not required to accept payment by the terms of the contract - they may sue the policyholder for compensation, and the contract's liability coverage would (or should) apply.

Double Indemnity

"Double Indemnity" is a term specific to life insurance policies, in which the amount paid is doubled in the event that the death is deemed "accidental." The offer of double indemnity must be explicit (otherwise, it may be treated as overlapping coverage).

Consumer advice: The terms of such policies tend to be so strict that very few deaths can be deemed "accidental." Unless a person is prone to accidents (by their profession, leisure interests, clumsiness, or lack of common sense), such coverage is generally deemed not to merit the premium.

Overlapping Coverage

It is entirely possible that an individual may have multiple insurance policies that cover the same loss, and may have grounds to collect multiple payments from multiple insurers. This largely depends on the precise wording of the policies in questions.

In most instances, an insurance policy will include a provision for overlapping coverage to discourage fraud (buying five policies on a car, then driving it off a bridge to collect far more than the loss is objectively worth). Such clauses generally void coverage in instances where the insured has coverage under another policy for the same loss.

Where overlapping coverage exists from separate insurers, the companies may voluntarily agree to a decision, or they may take the matter to court to decide who must pay. Precedents have been set for splitting the cost, for the first policy (based on the date signed) to bear the burden, and for the more specific policy to bear the burden. There are no standard practices.

It is vague, but seems possible, that overlapping coverage may entitle an insured to multiple payments from multiple insurers - but would that be fraudulent? Need research.

Indemnity Policies

The term "indemnity" is also used in a narrower context, to indicate that a cash payment is made directly to the insured in the event of a loss. This is to differentiate cash settlements from a "pay on behalf" coverage, in which the insurer has the option to pay third parties (for example, an auto repair shop) to restore the policyholder's property rather than paying the policyholder directly. The latter practice is more widely in use, as it discourages fraud.

Risk

Central to the concept of insurance is the element of risk: insurance safeguards the insured against the risk of losses in the future. Policyholders are motivated to purchase insurance by their unwillingness to face risk. Insurers are motivated to sell insurance by their willingness to face the exact same risk.

Insurable Risks

While an insurer may choose to underwrite any risk, even if it is not in his financial interest to do so, it is commonly held that insurable risks have certain qualities:

  1. A large number of homogeneous units. In most cases, insurance covers similar items (automobiles, houses, boats, etc.) that face similar risks, such that the law of averages will play out, enabling the insurer to predict the total loss of the population.
  2. Accidental or Uncertain Loss. The event that is insured is unusual (not routine wear and tear) and is not deliberately caused by the policyholder. It is also suggested that the risk should be possible, but not definite, though the existence of life insurance suggests that even a definite event can be insured.
  3. Substantial Loss. The amount of the loss must be substantial, from the perspective of the insured, in order for insurance protection to be considered valuable.
  4. Objective Loss. The loss must be observable, or based on objective criteria, such that there should be a clear resolution to the question of whether a loss occurred.
  5. Financially Measurable Loss - For calculation purposes, the insurer must be able to determine the probability of loss and the average cost of payments to the insured in order to determine premiums. Since insurance is a financial product, the calculation should result in a dollar value (even though the indemnification may be a repair or replacement in lieu of a cash settlement).
  6. Reasonable premium. The amount of the premium must be reasonable, from the perspective of the insured, in order for insurance protection to be valuable. If the premium is seen as being more than the replacement value of the item, or out of line with the likelihood of a loss occurrence, then the insurer will not be salable.
  7. Limited risk of catastrophic losses. It is not commercially viable to sell insurance when there is a high risk that multiple policyholders will suffer a catastrophic loss. The example is selling earthquake insurance in one town - if the event occurs, all policyholders will suffer total loss, and the insurer will be unable to pay.

It is generally held that risks that meet the preceding qualifications are "insurable" - i.e., it is commercially feasible to offer insurance against those risks - and those that do not are not insurable. However, there are some companies (Lloyds of London, for example) that are renowned for their history of underwriting bizarre risks that most insurers shy away from.

Underwriting Risk

The term "underwriting" refers to the practice by which insurers select the risks they will cover and decide how much to charge each insured as a premium for providing coverage for those risks. Ultimately, the underwriter makes two decisions:

  1. Whether to underwrite a risk at all - This determines what coverage will be provided, and a risk may be fully covered, partially covered, or not covered at all
  2. How much premium to charge for underwriting risk - This is generally determined by calculating the amount of loss they are statistically likely to have to pay for, as an aggregate of their consumers' individual risk.

Underwriting is made by mathematical criteria: if an insured has a 2% chance of taking a $5000 loss in a given year, a fair premium would be $100 - such that if the statics play out in reality, the underwriter will collect exactly as much funds in premiums as he needs to pay out the claims.

However, because policies are legal contracts that pertain to a period of time in the future, the underwriter assumes additional risk when selling a policy: if there are more claims than the underwriter predicted, he will have to pay them, but will not be able to raise premiums.

With this in mind, underwriters generally make their estimates conservatively, and will "pad" their estimates to allow for particularly bad years and add additional amounts to the premiums to cover their own operating expenses and generate a profit.

Competition reins in underwriters from gouging customers (if an insurance company charges a high premium, customers will flock to one that offers a lower one for the same coverage), and there is also the option for customers to decide insurance isn't worth the money at all.

It's a delicate balancing act: charge too much premium and lose customers, charge too little and be bankrupted when the claims roll in.

Claims

A "claim" is a demand for payment on the part of the insured or any person to whom the insurance policy may require payment to be made - called a "claimant" hereafter.

To collect, the claimant must contact the insurer and provide information, as required by the policy, to establish that an insured loss has occurred. The claimant may state the remedy to which they feel they are entitled, the insurer may make their own estimation of the remedy, and/or the two may fight it out to arrive at a solution that satisfies the provisions of the policy.

A claim may be subject to a deductible - a value of loss that must be borne by the insured before insurance will provide any remedy. There may also be a specified maximum amount the insurer will pay, documented as a policy limit. Also, the insurer may pay a fixed amount (a percentage of the cost) rather than the full value. All of these should be detailed as conditions of the policy.

One special note: deductibles and policy limits may be aggregated over the duration of a policy rather than applied on a per-incident basis. For example, if a house is damaged twice within the term of the insurance policy, the insured may have paid their full deductible on the first incident and owe no deductable the second time. Also, if the damage from the two incidents, together, exceeds the policy limit, the insured may not be fully reimbursed for the second loss.

Caveat Emptor: insurance policies are often written so that limits are aggregated, but deductibles are not.

Coinsurance

Coinsurance is a fairly important concept in property insurance: it requires a policyholder to insure property for at least a certain percentage (usually 80%) of its fair market value. Insuring an item for less than its worth is an inadvisable practice, but one which some consumers will use to save on premiums.

A coinsurance requirement impacts the amount of settlement in the event of a loss by the degree to which the actual value exceeds the insured value. For example: the owner of a painting appraised at $100K chooses to insure it for only $20K (20% of its value). If the painting is damaged and its value is reduced to $70K, the insurance company may pay only $6K (20% of the value of the damage, corresponding to the percentage of the total value insured) instead of the full $30K.

Running afoul of a coinsurance requirement is often accidental: the item increases in value and the policy is not updated to reflect the actual value. An "agreed amount endorsement" can be added to a policy to specifically exempt the coinsurance requirement (and precipitating penalty should a claim be filed), compelling the insurer to pay the full amount of the loss, subject to policy limits.

In some instances, coinsurance can be a deliberate and explicit agreement, by which the policyholder seeks to insure an item for partial value. In such cases, only the covered amount is paid in the event of a total loss, and a lesser loss may pay a percentage of the damages (equal to the percentage insured: insured value divided by actual value) rather than the actual amount of damages.

Coinsurance is also used to describe the partial coverage that is common in health insurance policies that pay a percentage of the cost of care (which may vary at certain amounts). When coinsurance is a fixed dollar amount rather than a percentage, it's commonly called a "copayment."

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