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Inside this Article
Principles
of insurance
Commercially insurable risks typically share seven common
characteristics.
Insurance -A
large number of homogeneous exposure units
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The past 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
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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. Lloyds 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.
Insurance---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.
Insurance---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.
Insurance---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.
Insurance---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.
Insurance---Calculable Loss
There are two elements that must be at least escheatable, 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.
Insurance---Limited Risk
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%. 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 effect 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 insurers, or are insured by a single
insurer who syndicates the risk into the reinsurance market.
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