INSURANCE
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.
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