An Overview of the Different Types of Insurance
An insurance entity is an economic entity that allows the sharing and transfer of risks. Types of insurance can be classified according to the perils insured or by the type of insurance program. There is also a primary distinction between private and social insurance.
Private insurance protects individuals, businesses, and other organizations against the particular risks that they are subject to. This type of insurance is funded by premiums paid by the insured to the insurance company. Private insurance is voluntary and the insurance is acquired through contract.
Social insurance, on the other hand, is usually compulsory and is funded by the government directly, and indirectly by the taxpayers. The benefits of social insurance are determined by law, and the benefits are usually only sufficient to maintain a minimum standard specified by law. The largest and most prominent examples of social insurance programs in the United States are the Social Security and Medicare programs.
Private insurance can be classified into 3 broad categories: life insurance and annuities, health insurance, and property and liability insurance.
Life insurance pays a lump sum to the beneficiaries if the insured dies prematurely. Typically, life insurance is purchased to provide support for the dependents of the insured. Life insurance can also be an investment vehicle, because earnings can accumulate tax-free and can provide a cash value to the policy owner. Annuities are a different type of life insurance, in that an income is paid to the policy owner for a fixed duration or for the life of the policy owner or his spouse. Annuities are considered a form of longevity insurance because the payments can last a lifetime of the policy owner, thereby preventing the insured from outliving his assets. The source of income used to pay annuities comes from the premiums paid by the policy owner, also known as the annuitant, by the interest earned on the premiums, and by the liquidated principal of other annuitants in the pool who die earlier than expected.
There are several types of insurance that provide financial reimbursement for sickness, bodily injury, or accidental death. Health insurance protects against sickness or bodily injury. Disability income insurance provides an income of the insured becomes disabled. Long-term care insurance protects against extended illnesses or disability that results in the insured not being able to care for themselves. Accidental death and dismemberment insurance pays if the insured loses limb or life from an accident.
Property and liability insurance protects against the loss from property damage or loss from legal liability. Property insurance covers damage to property, which includes real estate, buildings, furniture, fixtures, and personal property against such perils as fire, windstorms, lightning, and hail. Originally property insurance was only available for fire, but the list of perils has grown considerably in recent years. There are 2 types of property insurance: named-peril coverage, which covers damage only from some specified perils, and open-peril coverage, which covers any peril not excluded by the insurance contract. Property insurance can cover actual losses and indirect losses, such as lost income or additional expenses incurred because of the primary loss. Most common type of property and liability insurance is homeowners insurance.
Marine insurance, in spite of the name, protects against losses in the transportation industry including those that occur strictly on land, such as trucks or railroads. There are 2 types of marine insurance: ocean marine and in land marine. Ocean marine insurance covers ocean-going vessels and/or cargoes and the shipowners liability. Originally, ocean marine insurance only covered cargo while it was on the ship, but most modern policies now cover cargo from warehouse to warehouse. Land marine insurance covers transportation and communication over land and the infrastructure thereof, including bridges, tunnels, pipelines, power transmission lines, cell towers, and radio and television communication equipment. Coverage has recently been expanded to cover property located outside the domicile of the owner.
Automobile insurance covers most types of motor vehicles, including liability associated with operating them. Depending on the chosen coverage, auto insurance covers medical payments for injuries caused by auto accidents, damage caused by uninsured an underinsured motorists, and collision and other damage to the vehicle, and theft of the vehicle. Auto insurance consists of 3 types of coverage: liability, collision, and comprehensive. Most states require liability coverage, which covers injuries and damage to others caused by the insured. Collision coverage covers damage caused by a collision, while comprehensive coverage covers all forms of loss not caused by a collision, such as windshield damage caused by stones, vandalism, and theft.
Liability insurance covers most types of legal liabilities that result from owning property or operating a business and individual liability, such as libel or defamation.
Equipment breakdown insurance was 1st marketed in the late 1800s to cover the explosion hazard of early boilers. Hence, it was often called boiler and machinery insurance. Nowadays, this coverage covers almost all kinds of equipment breakdowns, especially as business becomes more automated. Companies that sell equipment breakdown insurance also employ inspectors that inspect the property periodically, which is another reason why the businesses purchase the insurance, because it may prevent or mitigate losses, as well as compensating for those losses. Burglary, robbery, and theft insurance protect property of the insured from the criminal acts of people who are not employees of the insured. Coverage for employees is covered by surety and fidelity bonds.
Cybersecurity insurance, or cyber insurance, protects against losses incurred because information systems were breached or impaired. Cyber insurance usually covers data breaches, computer viruses, and cyber extortion. These specific policies are sold because such coverage is generally excluded from most property and liability insurance policies.
Trade credit insurance is purchased by manufacturers and wholesalers to cover nonpayment by their customers that exceeds the normal amount of bad debt loss that most businesses suffer to some degree. However, the business is usually required to pay a percentage of the loss.
Title insurance provides against losses because of defects in the title of certain types of property, especially real estate. Generally, the law requires that specific procedures be followed precisely each time titled property is transferred. Therefore, the buyer of such property may suffer a loss if the title is defective and the buyer cannot maintain ownership of the property. In such cases, title insurance will compensate the buyer for the losses incurred. A unique aspect of title insurance is that it covers past events rather than future events. Generally, a title insurance company will conduct a title search to ensure that the title is good based on current evidence. However, the title may have hidden defects that may only become evident later.
Surety and fidelity bonds represent a special type of risk transfer involving 3 parties: the surety, principal, and the obligee. Surety bonds are mostly used for contract construction and court actions. The principal pays for the bond, but the obligee receives the proceeds of the principal fails to complete the work that was bonded. The surety bond guarantees that the principal is honest and has the financial wherewithal and ability to competently perform the work for which the bond covers. If the principal fails to carry out his obligation, then the surety will pay the obligee, so that another company can be hired to complete the work. To recover its losses, the surety will sue the principal.
Fidelity bonds, otherwise known as employee dishonesty insurance, covers theft or other forms of dishonesty by the employees of the principal. The surety pays the principal for any covered losses because of the employees.
The primary objective of any private insurance company is to make a profit. To do so, insurance company sets underwriting guidelines to eliminate undesirable insurance applicants and restricts coverage only to those insurance applicants who are expected to have minimal losses. Thus, for instance, insurance companies will not provide health insurance to elderly people, since their health care costs generally increases with their age. However, the objective of most societies, more or less, is to take care of the less fortunate.
Modern social insurance began in 1884 in Germany, under Otto von Bismarck. Their social insurance program provided 3 types of coverage: sickness insurance was provided for all employees; accident insurance was provided for work-related injuries, which was probably the 1st workers compensation system, and finally coverage was provided for disability and old age. These types of social insurance programs spread to the rest of Europe and over to the United States, and thence to the rest the world. In the US, the state started requiring employers to carry workers compensation, then during the Great Depression, the federal government passed the Social Security Act of 1935, creating the Social Security system.
Most modern countries now have some types of social insurance. In the United States, Social Security provides income for older Americans and Medicare offers health coverage for those who are at least 65. Every employer in the United States is required to carry workers compensation, to cover injuries to its workers.
Social insurance is designed to benefit many people, but without making a profit. There is no profit motive for providing social insurance, because certain groups cannot be covered profitably. Instead, government agencies or other organizations that are compelled by law, such as the requirement that businesses carry workers compensation, provide the social insurance. Because there is always some subsidization by those who are better off to those who need the insurance, insurance companies would not be able to compete by providing such insurance, since other companies will seek to insure only the good risks and exclude the bad risks, thereby making it more expensive for the insurance companies holding the bad risks to provide coverage. This is why either the government provides social insurance or compels other organizations, such as businesses, to provide social insurance. Usually, those who are insured are covered by contributions to the insurance program, but the benefits of the program are often greater for poorer people than for richer people compared to the contributions that they have made. For instance, poorer people generally receive higher Social Security benefits per dollar contributed than richer people, even though richer people usually get a larger payout.
The law requires social insurance coverage and determines the benefits. Social insurance also differs from welfare or public assistance, in that eligibility for social insurance is based on contributions by the covered people rather than by need. Nonetheless, the poor generally benefit more from social insurance because they usually receive more benefits per dollar of contribution than wealthier people.
Previous to 1908, injured workers had to sue the employer to pay for injuries that they sustained on the job. However, states started requiring workers compensation programs that would be used to pay injured workers without them having to resort to the courts. Although workers compensation is a type of social insurance, the insurance is generally sold by private insurers and by state workers compensation funds.
Workers compensation insurance is purchased by the employer to cover employees working in the business. Workers compensation insurance is compulsory insurance: every business that has employees must cover their workers, either by purchasing workers compensation or providing coverage through self-insurance.
To supplement workers compensation, California, Hawaii, New Jersey, New York, Rhode Island, and Puerto Rico have enacted compulsory temporary disability laws that require disability coverage for non-occupational disabilities, much like railroad employees have under their unemployment compensation program. Participation is compulsory. The states act as insurers and prescribe the benefits under their program. In most of the states, private insurance companies can compete with the state in providing this coverage.
Social Security, Unemployment Insurance, and Medicare
The Old-Age, Survivors, and Disability Insurance Program (OASDI), otherwise known as Social Security, only provided retirement benefits when it was enacted in 1935. Survivor benefits were added in 1939, disability benefits, in 1956, and the program was greatly expanded in 1965 by the addition of Medicare. Virtually every person and their dependents in the US, who has worked at least 10 years, and paid Social Security and Medicare taxes is entitled to receive benefits. Only railroad employees and other government employees who have their own retirement program do not qualify.
Railroad employees have their own social insurance — called the Railroad Retirement, Disability, and Unemployment Program, administered by the Railroad Retirement Board — that provides retirement and survivor benefits, and disability coverage. Additionally, railroad employees also have their own unemployment insurance, covering unemployment resulting from disability or for any other reason.
Unemployment insurance pays workers who become unemployed because they were laid off or were fired because of acts that were not willful, such as incompetency. Before 1935, a few states have enacted unemployment insurance, but most other states were reluctant to follow, fearing that the tax assessment to finance unemployment insurance would burden the industries within the state, making them less competitive. To motivate states to offer unemployment insurance, the Social Security act of 1935 impose a 1% tax on employers with at least 8 employees, but allowed the employers to offset 90% of the tax with a credit from paying into a state unemployment compensation program. Hence, the federal tax equalized the tax rate for unemployment insurance for all states and impelled states to provide their own unemployment compensation program so that they could receive most of the money paid into the unemployment compensation system instead of having it paid to the federal government.
Medicare became effective July 1, 1966, providing health insurance to most citizens who were at least 65 or who had certain disabilities. Medicare has 3 parts. The 1st part, Part A, is financed by Medicare taxes on employers and employees and provides hospitalization insurance. Part B is voluntary and covers physician services and other medical expenses not covered by Part A. Part D is the Prescription Drug Coverage that was enacted by the Medicare Prescription Drug Improvement and Modernization Act of 2003, but 1st implemented on January 1, 2006, and as the name implies, covers prescription drugs.
Public Financial Insurance Programs
Both state and federal governments have programs to insure bank deposits, security deposits, pensions, and even insurance companies. Governments provide these specific programs as a means to provide greater protections than insurance companies can offer and to improve the function of the economy. The main reason to protect cash or securities that are deposited with financial institutions is because such institutions are important to the function of the economy, so people are more likely to use financial institutions if the government guaranteed their deposits. This in turn, allows financial institutions to invest more money into the economy by providing loans and stimulate spending, which helps the economy to perform at an optimal output.
The federal government has 4 main financial insurance programs: FDIC, The National Credit Union Administration, The Securities Investor Protection Corporation, and the Benefit Pension Benefit Guaranty Corporation.
The Federal Deposit Insurance Corporation (FDIC) is a public corporation created by the federal government in 1933 to prevent the massive losses occurring during the Great Depression because of many bank failures. When people lose their money, this contracts the money supply and lowers the velocity of money, which has a detrimental effect on the economy. Additionally, the banks have less money to loan out, thereby reducing investments by businesses. Currently, up to $250,000 per individual is guaranteed, so that if the bank becomes insolvent or fails, then the depositor will be reimbursed up to the limit. This limit also applies separately to different ownership accounts, such as joint accounts and retirement accounts, so that an individual may receive more than the limit if the money is spread among different types of accounts.
The National Credit Union Administration (NCUA) is a similar program for members of the credit union, with the same limit of $250,000 per depositor.
The Securities Investor Protection Corporation (SIPC) is a public corporation created in 1970 and protects up to $500,000 of securities, including up to $250,000 in cash, held by a registered broker for a customer against failure of the broker or from unauthorized trading of the customer's account. All registered brokers are required to carry SIPC insurance. Note, however, that the SIPC only protects against the failure or malfeasance of the broker, not against market risk of the deposited securities.
The Pension Benefit Guaranty Corporation (PBGC) was created as part of the Employee Retirement Income Security Act of 1974 (ERISA) to protect pensions offered by private employers to their employees against the insolvency of the employer, in which case, the employees would receive their vested benefits, up to a specified maximum.
The main financial insurance program offered by states is the protection against the failure of insurers. States provide these programs instead of the federal government because most of the laws governing insurance companies are within state jurisdiction. Since states have a natural interest to prevent the insolvency of their insurers, they have jurisdiction over enacting laws that would help to prevent their insolvency. All states have insurer insolvency funds to pay for benefits to beneficiaries of the failed insurance company. Most of these insolvency funds are financed by assessments on surviving insurance companies within the state after one or more insurers have failed.
Some states — Maryland, Michigan, New Jersey, New York, and North Dakota — also have unsatisfied judgment funds that pays for injuries to victims of automobile accidents, where the negligent driver is uninsured or underinsured. Most of these funds are financed by an added fee on motor vehicle registration or by an auto premium tax. Most states without unsatisfied judgment funds require that drivers have uninsured or underinsured motorist coverage, where compensation is paid to the injured party by their own insurance company if the negligent party cannot pay. A disadvantage to unsatisfied judgment funds and the uninsured or underinsured motorist coverage is that the maximum payment is limited to the usually low minimum requirements of coverage stipulated by that state. Another main problem with this type of coverage is that the injured party must prove that the other party was negligent and is unable to pay for damages.