Insurance – Part I
Our next four postings will deal with risk, and in particular, the concept of risk transfer via insurance. Everyone on earth faces risks of various kinds. Premature death, loss of a dwelling, liability for causing a loss to another party, inability to perform activities of daily living and suffering a severe financial loss are only some of the risks we encounter in life. We may have choices to (1) Retain the risk (2) Avoid the risk (3) Reduce the risk and (4) Transfer the risk to another party. Insurance involves option #4 in that it allows us to bring in another entity which will assume some of the financial burden caused by the catastrophic event.
The insurance mechanism “involves the insured assuming a guaranteed and known relatively small loss in the form of payment to the insurer (the premium) in exchange for the insurer’s promise to compensate the insured in the event of a covered loss.”1 Transferring risk has been practiced for thousands of years as ancient Chinese and Babylonian traders saw a need to protect their wares from theft or an unfortunate accident at sea. It has long been known that the insurance mechanism will only function properly if the probability of the insured event can be estimated or calculated. Likewise, that probability must be somewhat less than a “sure thing” (100%) or else no party would be willing to assume the risk that has been transferred. The premium that is charged for an insurance policy is determined by the interaction of the probability of occurrence and the expected cost of paying a claim. If the insurer estimates a high probability of a claim, it will either decline to issue a policy or demand a premium that is very high.
There are other elements of insurance that are important to understand. A policy will not be offered if the purchaser does not have an “insurable interest.” This means the purchaser has a need to protect against the adverse consequences against which the insurance is being offered. For instance, the purchaser of a life insurance policy needs to establish that they would suffer economically if the insured person were to pass away prematurely. Obviously, one spouse would be affected by the death of the other, but this might also be the case with the untimely death of one of two business partners. Conversely, you may value the friendship of one of your neighbors, but an insurance company would question your insurable interest in purchasing a life insurance policy on that person’s life. Insurable interest must exist at the time of policy application, but not necessarily at the time of loss. Clearly, insurers do not want to create circumstances where someone profits from the untimely death of an unrelated individual.
Insurance policies are legal contracts and require four essential elements in order for the contract to be enforceable. (1) Parties to the insurance policy must have legal capacity to enter into a contract. Examples of parties unable to do so include minors, persons who lack mental competency or those under the influence of drugs or alcohol. (2) The insurance contract must have a legal purpose, so intentional acts such as arson or murder lack the legal aspect for purchasing insurance. (3) There must be an “agreement” which includes an offer to purchase (created by completion of a policy application) and an acceptance which takes the form of an application approval and policy issuance. (4) Lastly, there must be “consideration” or an exchange of value in order to make the contract binding. The insured’s consideration is the payment of premium, while the insurer’s consideration is the promise to “indemnify” the policy holder. Indemnification means to compensate for a loss, or to make one whole again. Insurance is designed to restore an insured to the same physical or financial condition which existed prior to the loss, without a profit or a gain.2
2A. D. Banker & Company, “Life and Health” pgs. 7-8.