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Insurance
Insurance, in law
& economics, is a
kind of risk
management primarily
used to hedge
against the risk of
a contingent loss.
Insurance is defined
as the equitable
transfer of the risk
of a loss, from one
entity to another,
in exchange for a
premium. An insurer
is a company selling
the insurance. The
insurance rate is a
factor used to
determine the
amount, called the
premium, to be
charged for a
certain amount of
insurance coverage.
Risk management, the
practice of
appraising and
controlling risk,
has evolved as a
discrete field of
study and practice.
Principles of
insurance
Commercially
insurable risks
typically share
seven common
characteristics
1. A large number of
homogeneous exposure
units. The vast
majority of
insurance policies
are provided for
individual members
of very large
classes. Automobile
insurance, for
example, covered
about 175 million
automobiles in the
United States in
2004. The existence
of a large number of
homogeneous exposure
units allows
insurers to benefit
from the so-called
“law of large
numbers,” which in
effect states that
as the number of
exposure units
increases, the
actual results are
increasingly likely
to become close to
expected results.
There are exceptions
to this criterion.
Lloyd's of London is
famous for insuring
the life or health
of actors, actresses
and sports figures.
Satellite Launch
insurance covers
events that are
infrequent. Large
commercial property
policies may insure
exceptional
properties for which
there are no
‘homogeneous’
exposure units.
Despite failing on
this criterion, many
exposures like these
are generally
considered to be
insurable.
2. Definite-Loss.
The event that gives
rise to the loss
that is subject to
insurance should, at
least in principle,
take place at a
known time, in a
known place, and
from a known cause.
The classic example
is death of an
insured on a life
insurance policy.
Fire, automobile
accidents, and
worker injuries may
all easily meet this
criterion. Other
types of losses may
only be definite in
theory. Occupational
disease, for
instance, may
involve prolonged
exposure to
injurious conditions
where no specific
time, place or cause
is identifiable.
Ideally, the time,
place and cause of a
loss should be clear
enough that a
reasonable person,
with sufficient
information, could
objectively verify
all three elements.
3. Accidental-Loss.
The event that
constitutes the
trigger of a claim
should be
fortuitous, or at
least outside the
control of the
beneficiary of the
insurance. The loss
should be ‘pure,’ in
the sense that it
results from an
event for which
there is only the
opportunity for
cost. Events that
contain speculative
elements, such as
ordinary business
risks, are generally
not considered
insurable.
4. Large-Loss. The
size of the loss
must be meaningful
from the perspective
of the insured.
Insurance premiums
need to cover both
the expected cost of
losses, plus the
cost of issuing and
administering the
policy, adjusting
losses, and
supplying the
capital needed to
reasonably assure
that the insurer
will be able to pay
claims. For small
losses these latter
costs may be several
times the size of
the expected cost of
losses. There is
little point in
paying such costs
unless the
protection offered
has real value to a
buyer.
5.
Affordable-Premium.
If the likelihood of
an insured event is
so high, or the cost
of the event so
large, that the
resulting premium is
large relative to
the amount of
protection offered,
it is not likely
that anyone will buy
insurance, even if
on offer. Further,
as the accounting
profession formally
recognizes in
financial accounting
standards, the
premium cannot be so
large that there is
not a reasonable
chance of a
significant loss to
the insurer. If
there is no such
chance of loss, the
transaction may have
the form of
insurance, but not
the substance. (See
the U.S. Financial
Accounting Standards
Board standard
number 113)
6. Calculable-Loss.
There are two
elements that must
be at least
estimable, if not
formally calculable:
the probability of
loss, and the
attendant cost.
Probability of loss
is generally an
empirical exercise,
while cost has more
to do with the
ability of a
reasonable person in
possession of a copy
of the insurance
policy and a proof
of loss associated
with a claim
presented under that
policy to make a
reasonably definite
and objective
evaluation of the
amount of the loss
recoverable as a
result of the claim.
7. Limited risk of
catastrophically
large losses. The
essential risk is
often aggregation.
If the same event
can cause losses to
numerous
policyholders of the
same insurer, the
ability of that
insurer to issue
policies becomes
constrained, not by
factors surrounding
the individual
characteristics of a
given policyholder,
but by the factors
surrounding the sum
of all policyholders
so exposed.
Typically, insurers
prefer to limit
their exposure to a
loss from a single
event to some small
portion of their
capital base, on the
order of 5 percent.
Where the loss can
be aggregated, or an
individual policy
could produce
exceptionally large
claims, the capital
constraint will
restrict an insurers
appetite for
additional
policyholders. The
classic example is
earthquake
insurance, where the
ability of an
underwriter to issue
a new policy depends
on the number and
size of the policies
that it has already
underwritten. Wind
insurance in
hurricane zones,
particularly along
coast lines, is
another example of
this phenomenon. In
extreme cases, the
aggregation can
affect the entire
industry, since the
combined capital of
insurers and
reinsurers can be
small compared to
the needs of
potential
policyholders in
areas exposed to
aggregation risk. In
commercial fire
insurance it is
possible to find
single properties
whose total exposed
value is well in
excess of any
individual insurer’s
capital constraint.
Such properties are
generally shared
among several
insurer, or are
insured by a single
insurer who
syndicates the risk
into the reinsurance
market.
- Courtesy Wikipedia
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