Insurance

Insurance is the pooling of money by a company from a group of people or organizations, to pay for the fortuitous losses that any of them may suffer. The money that the people pay to the insurance company is called the premium, and for this premium, the company promises to indemnify any of its customers for covered losses. The company may also provide risk management services.

Another way to look at it is that insurance involves the pooling of losses among its customers. In return for losing a little money in the form of a premium, the customers are indemnified against a large loss. Thus, the average loss among a group of people is substituted for actual losses.

To illustrate, consider a sample of 1,000 farms, and suppose that each farm were identical, and had the same value of $300,000 for the house and barn. Over the years, it was discovered that about 1 farmer would have a total loss every year. If a farmer's buildings burned completely, the farmer would be out of $300,000, but if each farmer paid into a fund every year to pay for the fires, then each would only have to pay 300,000/1,000 = $300 per year. Thus, for $300 per year, each farmer can avoid a loss of $300,000 if he suffers a fire that destroys both house and barn. The Amish, a religious sect, do something similar, but instead of pooling money, they pool labor. If a farmer's barn burns down, for instance, then other members of the community pitch in and rebuild the barn. Thus, in exchange for providing some labor periodically, each farmer is protected against major losses.

Insurance is the transfer of risk to an insurance company, which pools the losses of many people to provide indemnification for any who suffer covered losses. An insurance company also invests the premiums, since otherwise it would lose the opportunity cost of the money, usually in the form of interest, while it holds it. For a private insurance company to be a going concern, it must earn enough money from premiums and investments to pay not only for the losses of those covered, but also to pay to operate the company and to earn a profit. However, for any private insurance company to be able to insure a risk, the company's payout must be fairly predictable and the premiums charged must be affordable.

Insurable Risks

Because private insurance companies are businesses that want to make a profit, there are only certain risks—known as insurable risks—that private insurers are willing to cover. Almost all risks insured by insurance companies are pure risks, which are risks where there is no possibility of profit.

Insurance companies also do not insure against predictable losses, such as wear and tear, and inherent vice, which is the self-destruction of property caused by the nature of the thing itself, such as the rotting of fruit.

Affordable Premiums

Several requirements must be satisfied for an insurance company to be able to offer affordable premiums. First, the premium for the insurance must be affordable; otherwise few people would buy it, thereby spreading the risk among fewer people. With fewer people insured, the objective risk of the pool would be higher, because actual losses would be less predictable. Therefore, higher premiums would have to be charged to cover the increased objective risk.

Secondly, the premium must be considerably less than the policy coverage; otherwise, people would simply self-insure.

Losses must be accidental and unintentional. If they were not, then a moral hazard would be created, where many people would cause losses to collect insurance. This would raise premiums to unaffordable levels, and make payouts by the company unpredictable, since the losses would not occur by chance. People would stop paying premiums if they knew that the premiums were used to enrich dishonest people. For instance, one reason why insurance companies rarely cover mental illness is because it is easily feigned, and thus, it would be difficult to prevent dishonesty.

Another requirement to keep premiums affordable is that the loss must be determinable and measurable. The reason for the loss must be determinable because an insurance company will only pay for a loss if the loss was for a covered reason. The loss must be measurable to know what to pay out, because an insurance company will only pay to cover the actual loss, and no more. If the insurance company paid more than the actual loss, then the insured could make a profit by causing partial losses, then collecting the entire amount from the insurance company. This would not only increase premiums because of the larger payout, but it would also create a moral hazard by motivating some people to cause losses to profit from insurance, raising premiums even more.

Predictable Payouts

Another basic requirement for a private insurance company to insure a risk is that the total payout would have to be fairly predictable in a large sample of the population. Although there would be some variation in total losses from year to year, these losses should not deviate too much from the mean over time. To be predictable, both the frequency and the severity of losses should be calculable. Since these calculations rely on the law of large numbers, there would have to be a large number of exposure units, the basic items that are insured. Without accurate forecasting, an economical premium cannot be calculated.

The law of large numbers is based on the observation that the greater the number of events that have a given or observed probability, the less the observed frequency will deviate from the expected frequency. As a simple example, consider the tossing of a fair coin. The chance, in any 1 toss, that it will come up heads or tails is 50/50, but if the coin were tossed 10 times, there is a small possibility that all 10 flips will yield heads. Even if it is not all heads or all tails, there is a very good chance that the observed frequency will deviate significantly from the expected 50/50 chance. However, if the coin were flipped 1 million times, then heads and tails will be more nearly equal.

Because most catastrophic losses, such as floods, earthquakes, and war, occur erratically, and usually with great destruction, both the frequency of occurrence and the severity of losses cannot be accurately forecasted, and, thus, catastrophic losses are usually not insured by private companies.

Underwriting and Adverse Selection

Insurance companies, like most companies, have competition. The better that an insurance company can calculate risks, the lower the premiums that it can charge and still make a profit. One way to do this is by underwriting, which is the selection and classification of insurance applicants according to the probable payout for that class.

For instance, it is observed that some people have more auto accidents than others. By classifying people according to the observed risk of accident, a lower premium can be charged to safe drivers and higher premiums to reckless drivers. If the same premium was charged for both types of drivers, then the premium charged would be higher for the safe drivers and lower for the reckless drivers than it would otherwise be. In other words, the safe drivers would be partially subsidizing the reckless drivers. In a competitive industry, subsidization will be eliminated because if 1 insurance company were charging the same premium for all drivers, then another insurance company would start selling cheaper insurance only to the safer drivers. Then the safe drivers would choose the cheaper insurance, and the company that was charging the same rate would lose its source of subsidy, and would be forced to charge a higher premium to the reckless drivers. Subsidization can only exist if the law forces insurance companies to charge the same premium to different classes with a different risk profile. Such is the case with sex discrimination. Although young men have more accidents than young women, the insurance companies cannot use sex as a factor in calculating premiums—thus, young women partially subsidize the premiums for young men.

Insurance companies have devised various methods for more accurately rating the risk profile of certain classes of people. Thus, factors used to determine premiums for automobile insurance include the number of points on a driver's record and the number of accidents caused by the driver in the past.

Another controversial factor for underwriting is the use of insurance scores, which are based on credit scores, because there is a large correlation between people with low scores and the number of claims that they file. This, too, is limited by state law in some respects.

Many of the factors that are indicative of someone's risk are determined from the information provided by the applicant in the insurance application. Since many high risk people know that providing truthful information will increase their premiums, they provide false information to get a lower premium. If the insurance company provides the coverage for a lower premium, then the company, because of adverse selection, will incur more losses than it expected. Adverse selection results from the tendency of some people with high risk profiles to provide false information to get standard premiums.

To prevent adverse selection, insurance companies verify the information, especially if a claim is filed. If material information known to the insured at the time of the application was false, then the insurance company does not have to pay the claim. Various clauses in its contracts also provide specific conditions under which a claim will not be paid, such as the presence of pre-existing conditions. For instance, if the claimant files a claim for a health condition that the claimant would have known about when he applied for the insurance, then the company will not have to pay the claim. Similarly, an insurance company will not pay if a claimant commits suicide shortly after buying life insurance.