A method of protecting against future financial loss. Through insurance, the risk of such loss is transferred to an insurance company or other insuring orga¬nization.
HOW INSURANCE WORKS
Combined Risks. Insurance purchasers substitute the cost of insurance for the possibility of much larger future losses. To illustrate, imagine that 200 people own antique automo¬biles, each worth $20,000. The owners realize that their cars could be stolen or destroyed in a fire or collision. Each there¬fore buys a policy that insures against such loss during the next 12 months. Through past experience, the company has found that an average of one out of every 200 antique cars it insures is stolen or destroyed each year. By charging each of the 200 owners $125, the company will accumulate a fund of 200 x $125, or $25,000. That amount will be enough to pay for the expected $20,000 loss. In addition, it will pay the company’s operating expenses, including sales commissions, salaries, rent, office expenses, taxes, and so forth and also fur¬nish a safety margin in case there is more than one loss. From the viewpoint of the policyowners, insurance removes the risk of financial loss of the types and amount covered by their policies.
Insurance companies are able to accept their policyholders’ risks because they insure many individuals and can rely upon the law of large numbers. They know that when a large number of individual risks are combined, the total amount of loss can be predicted with reasonable accuracy. Insurers do not predict which ones of the many risks they insure will have losses. Instead, they forecast the total amount of loss payments for the entire group. That amount plus the cost of operating the insurance business is divided among all of the policyholders.
Features of Insurable Risks. Not all risks can be in¬sured. Risks like gambling or investments that can result in either loss or profit generally are not insurable. Only pure risks, those whose outcome can be only loss or no loss, can be insured. The costs of fire, illness, and lawsuits are exam¬ples. But while many pure risks are insurable, some are not. Insurable risks usually have four main features.
1) There must be many similar loss exposures. Without this feature, insurers would not be able to make reliable fore¬casts of total insured losses.
2) Losses must be definite, measurable, and important. A definite loss is one that is obvious; its happening is clear and unmistakable. If insured losses were vague and indefinite there would be endless disputes between insured persons and insurers. Losses are measurable when their dollar amount can easily be determined. In contrast, the purely sentimental value of personal trinkets or souvenirs is not easily measur¬able and not readily insurable. Insured losses also must be important. They must be large enough to be worth insuring.
3) Losses must be accidental. This feature requires insur¬able losses to be unintended and unexpected by the policy¬holder. Intentional loss, such as arson or other damage known to have been purposely caused by a property owner, cannot be insured. An example of an expected loss is normal property depreciation; because it is not accidental, it is not insurable.
4) Catastrophic loss must be extremely unlikely. This means that large numbers of the insured objects must not be subject to simultaneous loss. Unemployment compensation is a type of risk that can involve catastrophic loss and therefore cannot be covered by private insurers.
Insurance Pricing. Insurance companies must charge enough to cover their costs. But in two important respects in¬surance pricing differs from the pricing of other products. The first difference is that when an insurer sells a policy it has no way of knowing what its costs for the policy will be. It cannot simply add up the cost of the labor, materials, rent, advertising, and so forth that have gone into “making” the policy. Instead, it must estimate the policy’s ultimate cost, primarily on the basis of past claims submitted by policy¬holders. The second difference between insurance pricing and the pricing of other products is that in the case of in¬surance the cost to the seller depends in part upon who the buyer is. Because insurance costs vary from one policyholder to another, different people must be charged different prices for policies providing the same kinds and amounts of insur¬ance.
Premiums and Rates. The price of an insurance policy is called its premium. Premiums are based upon an insur¬ance rate per exposure unit. For example, the exposure unit in life insurance is the number of thousands of dollars of insurance. If the rate for a particular policy is $15 per thou¬sand and the policy provides $50,000 of coverage, the pre¬mium is $15 x 50, or $750 per year. Various exposure units are used in other kinds of insurance. They include: in fire insurance, $100 of coverage; in workers’ compensation in¬surance, $100 of payroll; and in auto insurance, the number of autos insured.
Class Rates. Most insurance rates are class rates. That is, insured risks are classified on the basis of several im¬portant characteristics and all that are in the same class are charged the same rate per exposure unit. In life insurance, for instance, policyholders are classified on the basis of their age and sex. The rates reflect insurance company records of the likelihood of living and dying at various ages. Class rates are used in auto insurance also, but in this case the rates take into account a greater number of characteristics, including the territory in which the rate applies and the age, sex, marital status, and motor vehicle accident and conviction record of all drivers in the policyholder’s household.
WHO PROVIDES INSURANCE
Insurance is furnished by private insuring organizations and by governmental agencies.
Private Insurance Organizations. There are several types of private insurers.
Stock Insurance Companies. A stock insurance company is a corporation that is engaged in the business of insurance. Like any other corporation, a stock insurer is owned by its stockholders. They elect a board of directors, which appoints the officers responsible for operating the company.
Most of the policies issued by stock companies are non-participating. That means that dividends are not payable to the policyholders. Some stock life insurance companies do issue participating policies. In such cases the policyholders usually receive annual dividends. The dividends are a partial return of the annual premiums, reflecting the difference be¬tween the premiums charged and the amount needed by the company to cover its costs.
Mutual Insurance Companies. Mutual companies have no stockholders; they are owned by their policyholders. A mu¬tual company’s excess earnings, if any, are returned to its policyholders. The return may be in the form of the divi¬dends paid on participating policies or, in the case of short-term policies like auto or home insurance, may be in the form of a reduction in the premiums charged for renewal policies.
Reciprocal Exchanges. This type of insuring organization is sometimes called an interinsurance exchange. It is an asso¬ciation whose members exchange insurance. In other words, the members insure one another. In contrast, both stock and mutual insurance companies, as entities, insure their policy¬holders; their policyholders do not directly insure each other. The administrative duties of a reciprocal exchange are handled by an attorney-in-fact under authority granted by the policyholders.
Lloyd’s of London. The most famous insurer, Lloyd’s is also one of the oldest. Its beginnings go back to late-iyth century London, where Edward Lloyd’s coffeehouse became known as a place where shipowners could find men interested in insuring ships and cargoes. The shipowners would go from table to table at the coffeehouse and other men, called underwriters, would agree to insure portions of their risks. Operations today are basically the same.
Lloyd’s is not an insurance company; it is an association of individuals who provide insurance. The approximately 15,000 members are organized into about 350 groups, called syndicates. Each syndicate is headed by an underwriter, who decides which risks or portions of risks the syndicate will in¬sure. The syndicates operate much like insurance companies, but the security of their policies rests on the financial strength of the individual members. If it became necessary, each syn¬dicate member would be personally responsible for insured losses down to his or her last penny. Much of the fame of Lloyd’s of London is attributable to the insuring of unusual risks such as pianists’ fingers and prizes for holes-in-one at golf tournaments. However, the great bulk of the business insured at Lloyd’s is conventional ocean marine and other property-casualty coverages.
Health Associations. In the United States, nonprofit organizations have been established under special state laws to handle advance payment of hospital and medical services.
The best known are Blue Cross and Blue Shield plans. They usually are governed by boards of directors representing hospitals, the medical profession, and the general public. The plans offer service contracts for hospital or doctor care. Subscribers receive the specified hospital or medical service and the plan reimburses the hospital or doctor furnishing the
care.
CRIME INSURANCE
Crime insurance protects against loss of money or other property by dishonest acts. The auto and home insurance policies carried by families and individuals include this protection. In insuring business firms, a distinction is made between crimes com¬mitted by employees and those committed by other persons. Loss caused by the former is covered by fidelity bonds. Loss caused by people who are not employees of the insured organization is covered by policies that insure against specific types of crime.
Nonemployee Crime. Burglary and rob¬bery are the crimes most commonly in¬sured against. The distinction between the two perils is important, because a policy covering one may not cover the other.
Burglary means the taking of property by breaking into the place where it is kept. A safe burglary policy, for example, covers money or other property stolen by breaking into a locked safe. The policy requires that there be visible marks showing that the safe was forced open. A mercantile open stock burglary policy covers merchandise and equipment taken by burglars who break into or out of a locked building.
In contrast to burglary, robbery means taking property by violence or threat of vio¬lence. A business with robbery insurance is protected against crime loss if an employee or messenger is held up or killed. Some robbery policies also cover property taken by other criminal acts when an employee is aware of the act, such as if a person grabs some merchandise and runs out of a store with it.
Employee Crime. Burglary and robbery policies exclude losses caused by employees of the insured organization. Employee dis¬honesty losses are covered by contracts called fidelity bonds. The protection applies to the loss of money,-securities, merchan¬dise, or other property stolen by employees. It does not cover loss caused by any owner, partner, officer, or director. Fidelity bonds may be written to cover either employees listed by name, specified positions, such as cashier or accountant, or all employees without naming them or their positions. The last of these is called a blanket fidelity bond.
TRANSPORTATION INSURANCE
The risks of truck, train, plane, or ship transportation fall into either of two categories of insurance, inland marine or ocean marine. Neither of the terms is descriptive. Inland marine deals primarily with the risks of land transportation, while ocean marine may cover transportation on inland waters as well as on the high seas.
Inland Marine Insurance. Numerous loss exposures associated with motor, rail, and air transport are handled by inland marine insurance.
Property in Transit. Property being shipped from one place to another is subject to loss or damage from many sources. In¬surance can be either for a list of named perils such as fire, explosion, collision, flood, and so forth, or for all risks of loss that are not explicitly excluded. Policies may be written to cover single shipments or all shipments during a one-year period. Special transit policies have been designed for those who make frequent shipments by parcel post or by registered mail. Another special policy covers shipments by armored car.
Bailee Liability. Bailees are persons or organizations having temporary custody of property that belongs to others. Examples include truckers and other carriers, dry cleaners, and parking garages. Depending upon the circumstances, bailees are re¬sponsible for exercising certain degrees of care to protect the property in their control. A bailee who does not use the required care may be legally liable to the owners of prop¬erty that is damaged. Bailee liability insur¬ance covers that potential loss. Some bailee policies are designed to reimburse the property owners even if the bailee is not legally liable for the damage; such contracts are called bailees’ customers policies.
Fixed Transportation Property. This divi¬sion of inland marine insurance covers fixed property that is used to facilitate transpor¬tation, such as bridges, tunnels, and pipelines.
Floaters. Floaters are policies covering moveable property wherever the property is located. Building contractors, for instance, own earth-moving equipment, compressors, hoists, scaffolding, and other items that are moved from one job site to another and are subject to loss from many sources. A contractor’s equipment floater covers the property, both while at a particular location and while in transit. Other floaters have been designed to insure other kinds of property, ranging from photography equip¬ment to livestock, from wedding presents to oil drilling rigs.
Ocean Marine Insurance. Ocean marine policies furnish protection for four types of losses involving water transportation. The first is damage to the hull of the ship it¬self. Second, the cargo may be damaged. Cargo insurance usually is provided by means of an open contract that auto¬matically covers all shipments in which the policyholder has insurable interest. Third, there may be loss of freight, meaning the payment for transporting the cargo. Usually the shipowner will not be entitled to this payment if the cargo is not delivered. The potential loss of freight therefore is customarily made a part of the hull insurance. The last of the losses covered by ocean marine insurance is the cost of legal liability claims. Liability insurance protects the shipowner from bodily injury and property damage liability claims resulting from collisions and other incidents.
