Risk Management and Insurance
Lead Author(s): Rob Hoyt, David Sommer
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The text covers the foundations of risk management and insurance. The broad view of risk reflected in the concept of enterprise risk management is incorporated throughout the text, while still maintaining features that are important for introductory courses in risk management and insurance. The text considers property, liability, life, health, and income risks for both individuals and organizations. For all risks discussed, both insurance and non-insurance solutions are analyzed.
Insurance as a Risk Management Technique: Principles
Lee Colquitt is starting a custom construction business that will specialize in kitchen interiors. Lee has done this type of work in the past for other firms, but he is tired of working for others and now wants to control his own destiny. He has hired three workers that he knows well from prior jobs and is now acquiring office, display, and machine shop space. Lee hopes to begin operations within a month or so.
One of the issues in getting started is that of identifying and managing some of the pure risks that will be associated with the new business. Lee is familiar with the risk management process and has identified numerous risks with which he will be faced, but he’s not sure of the best alternatives for dealing with all of them. Because his business is just getting started, Lee has very little extra capital to cushion any losses; thus, he suspects that he will need to utilize insurance to a greater extent than might a larger, more established firm.
As Lee thinks about this issue, he realizes that he has never given the concept of insurance a great deal of thought. He has always taken for granted that it could be obtained to cover anything, but now Lee wonders if that is true. Are there some risks for which insurance is not available? Then there are various legal questions that Lee is also pondering. Can he buy insurance now to cover a business that is not yet operational? Does it matter whether he deals with an insurance agent or an insurance broker in arranging the coverage? If Lee accidentally buys more insurance than he really needs, how will that affect his recovery for a loss? And given all the uncertainties in his life now, what if Lee unwittingly provides a wrong answer or two on the application for insurance? Will all of his insurance be void? These and other similar issues are discussed in this chapter.
After studying this chapter, you should be able to
- Define insurance and explain how it differs from other methods of risk transfer.
- Identify situations that give rise to insurable interest and explain how this principle supports the principle of indemnity.
- State how the subrogation process works and how it is useful.
- Determine what makes a risk insurable.
- List the legal requirements of a contract and describe the distinguishing legal characteristics of insurance contracts.
- Differentiate between insurance agents and brokers and describe the sources for their authority.
- Define social insurance and explain the basic principles underlying most social insurance programs.
- Describe the central costs and values of insurance to society.
The general concept of transfer as a risk management technique was discussed in the chapter on Risk Management Techniques: Noninsurance Methods. Insurance is a special form of risk transfer and may be defined in two major contexts: as an economic or social institution designed to perform certain functions and as a legal contract between two parties, the insured (transferor) and the insurer (transferee).
THE NATURE OF INSURANCE
As an economic institution, insurance involves not only risk transfer but also pooling and risk reduction. Pooling is the sharing of total losses among a group. Pooling within a large group facilitates risk reduction, which is a decrease in the total amount of uncertainty present in a particular situation. Insurance accomplishes risk reduction by combining under one management a group of objects situated so that the aggregate losses to which the insureds are subject become predictable within narrow limits. Thus, overall risk for the group is reduced, and losses that result are pooled, usually through the payment of an insurance premium. Thus, through the insurance mechanism, insureds transfer various risks to the group and exchange a potentially large, uncertain loss for a relatively smaller certain payment (the premium).
Insurance is sometimes likened to gambling, because it is possible for one party to receive a great deal more than is given in the transaction—just as is possible in gambling. But from an economic standpoint, gambling and insurance are exact opposites. Gambling creates a new risk where none existed before, whereas insurance is a method of eliminating or greatly reducing an already existing risk.
Insurance is usually implemented through legal contracts, or policies, in which the insurer promises to reimburse the insured for losses suffered during the term of the agreement. Implicit in insurance transfers is the assumption that the insurer will indeed be able to pay whatever losses may occur. Sometimes, however, insurers become insolvent and are unable to keep their promises to pay insured losses. In such cases, insureds may have to bear the cost of losses that they had assumed had been adequately transferred through the purchase of insurance policies. Thus, when using insurance as a risk management technique, it is important to consider the financial condition of the insurer and the probability that it will be able to pay for all insured losses that may occur. Some of the factors to consider in this regard are discussed in Chapter 20.
There are some situations in which the purchase of insurance is the best way to manage a particular risk, due to the insurer’s ability to handle risk efficiently through the law of large numbers. But it must be stressed that insurance should never be automatically assumed to be the only way to deal with a given risk. Rather, it should be considered as one of many potential techniques available through the risk management process. In fact, many risk managers consider insurance as a method of last resort, to be used only when other risk management techniques are not sufficient by themselves. In the sections that follow, many of the important principles underlying the insurance mechanism are discussed.
PRINCIPLE OF INDEMNITY
The principle of indemnity is one of the most important precepts for many types of insurance—particularly for property insurance. According to this principle, the insured may not collect more than the actual loss in the event of damage caused by an insured peril. This principle serves to control moral hazards that might otherwise exist. Because insurance is designed to merely indemnify, or restore insureds to the situations that existed prior to a loss, the likelihood of intentional losses is greatly reduced because payment for losses will not exceed the value of the property destroyed—regardless of the amount of insurance that may have been purchased.
Another important result of the principle of indemnity is the typical inclusion in property insurance contracts of clauses regarding the existence of other insurance. The purpose of such clauses is to prevent the insured from taking out duplicate policies with different insurers in the expectation of recovering more than the actual loss. Typically, such clauses provide that all policies covering the same loss will share losses that occur. Different ways in which this sharing may occur are discussed in the chapter on Insurance as a Risk Management Technique: Policy Provisions (Chapter 6).
There are some exceptions to the application of the principle of indemnity in property insurance. One issue involves the appropriate way to measure losses. For example, suppose Alliance Corporation has 10-year-old office furniture that is destroyed in a fire. Should this loss be valued at what it would cost to replace the furniture with new furniture or with comparable 10-year-old furniture (if such could be found)? Although replacement with new furniture would technically violate the principle of indemnity, such is done in many property policies. This valuation issue is discussed in more detail in Chapter 6. Another exception to the indemnity principle arises from the valued policy laws that some states have enacted, whereby the insurer must pay the entire face amount of a fire insurance policy in the event of total loss of the insured object. Some transportation policies also are written on a valued basis, and it is assumed that the insured will take out insurance equal to the full value of the object. Finally, the principle of indemnity is not usually applicable in the field of life insurance. When the insured dies, no attempt is made to measure the amount of the loss. Instead, the full amount of the life insurance policy is paid upon the death of the insured.
The principle of indemnity in insurance serves to reduce moral hazard.
PRINCIPLE OF INSURABLE INTEREST
A fundamental legal principle that strongly supports the principle of indemnity is that of insurable interest, which holds that an insured must demonstrate a personal loss or else be unable to collect amounts due when a loss caused by an insured peril occurs. If insureds could collect without having an insurable interest, a moral hazard would exist, and the contract would be deemed contrary to public policy. The doctrine of insurable interest is also necessary to prevent insurance from becoming a gambling contract. An important reason for requiring insurable interest in life insurance is to remove a possible incentive for murder.
What Constitutes Insurable Interest
One important issue is determining which persons or organizations can have insurable interests. The legal owner of property having its value diminished by loss resulting from an insured peril has an insurable interest and can collect if he or she is able to demonstrate that a financial loss has occurred. But ownership is not the only evidence of insurable interest. For example, XMA Corporation leases a building under a long-term lease whereby the lease may be cancelled if a fire destroys a certain percentage of the value of the building. XMA has an insurable interest in the building because of the lease.
There are also other rights that are sufficient to establish an insurable interest in a property. Thus, the holder of a contract to receive oil royalties has an insurable interest in the oil property so that in the event of an insured loss, indemnity can be collected, the amount of the indemnity being measured by the reduction in royalty resulting from the insured loss. Likewise, legal liability resulting from contracts establishes insurable interest in property. For example, garage operators have an insurable interest in the stored automobiles for which they have assumed liability. Secured creditors, such as mortgagees, have an insurable interest in the property on which they have lent money. Building contractors have an insurable interest in property on which they have worked because they have a mechanic’s lien. In each of these latter two cases, loss of the building would endanger the ability to collect amounts due. However, general creditors—ones without specific liens on the property—are not regarded as having a sufficiently great property right to give them an insurable interest. In most states, however, a general contractor who reduces a debt to a judgment then has an insurable interest in the debtor’s property. A businessperson has an insurable interest in the profits expected from the use of property and in the expenses incurred in managing that property.
An insurable interest is always presumed to exist in life insurance for persons who voluntarily insure their own lives. An individual may procure life insurance and make anyone the beneficiary (the one who receives the insurance proceeds when death occurs), regardless of whether the beneficiary has an insurable interest. But one who purchases life insurance on another’s life must have an insurable interest in that person’s life. Thus, a business firm may insure the life of a key employee because that person’s death would cause financial loss to the firm. A husband or wife may insure the life of his or her spouse because the spouse's continued existence is valuable to the purchaser and the purchaser would suffer a financial loss upon the spouse's death. The same statement may apply to almost anyone who is dependent on an individual. A father may insure the life of a minor child, but a sister may not ordinarily insure the life of her brother. In the latter case there would not usually be a financial loss to the sister upon the death of her brother, but in the former case the father could suffer financial loss upon the death of his child. A creditor has an insurable interest in the life of a debtor because the death of the debtor would subject the creditor to possible loss.
Of course, there are practical limits as to the amount of life insurance an individual may obtain. Sometimes parties will attempt to avoid the insurable interest requirements in life insurance and use the contract as a wagering agreement. Courts will usually set aside such contracts. For example, two individuals met in a bar and after a short acquaintance, one agreed to insure his life and then assign the policy to the other if reimbursed for the premium. The insured person died, and the insurer refused to pay when the facts surrounding the application became known. The court upheld the insurer’s refusal to pay on the grounds that the transaction was conceived to use the life insurance policy as a means of effecting a wager. The intention was to avoid the requirements of insurable interest by having the person whose life was insured take out the policy with the sole purpose of transferring it to another who had no insurable interest.
An insurable interest likely exists in all of the following cases EXCEPT:
individual takes out a life insurance policy on his or her own life
a bank requires a borrower with a mortgage on his or her home to take out a homeowners' insurance policy
a spouse takes out a life insurance policy on the life of the other spouse
a friendly neighbor takes out a life insurance policy on his neighbor's life
When the Insurable Interest Must Exist
In property and liability insurance, it is possible to effect coverage on property in which the insured does not have an insurable interest at the time the policy is written but in which such an interest is expected in the future. For example, in transportation insurance a shipper often obtains coverage on the cargo it has not yet purchased in anticipation of buying cargo for the return trip. As a result, the courts generally hold that in property insurance, insurable interest need exist only at the time of the loss and not at the inception of the policy. However, if at the time of the loss the insured no longer has an interest in the property, there is no liability under the policy. For example, suppose that X Company owns and insures an automobile. Later X sells the car to Y Company, and shortly thereafter the auto is destroyed. X, which has no further financial interest in the car, cannot collect under the policy. Further, Y has no protection under the policy because insurance is said to follow the person and not the property. In other words, the policy purchased by X Company does not transfer to Y when the car is sold. Y would have to obtain its own coverage to be able to collect when the loss occurs.
In life insurance, the general rule is that insurable interest must exist at the inception of the policy, but it is not necessary at the time of the loss. The courts view life insurance as an investment contract. To illustrate, assume that a wife who owns a life insurance policy on her husband later obtains a divorce. If she continues to maintain the insurance by paying the premiums, she may collect on the subsequent death of her former husband even though she is remarried and suffers no particular financial loss upon his death. It is sufficient that she had an insurable interest when the policy was first issued. In a similar way, a corporation may retain in full force a life insurance policy on an employee who is no longer with the firm. A creditor may retain the policy on the life of a debtor who has repaid his or her obligation. In other words, in life insurance the general rule is that a continuing insurable interest is not necessary.
In property insurance, an insurable interest must only exist at the inception of the policy.
PRINCIPLE OF SUBROGATION
The principle of subrogation grows out of the principle of indemnity. Under the principle of subrogation, one who has indemnified another’s loss is entitled to recovery from any liable third parties who are responsible. Thus, if Dave negligently causes damage to Ed’s property, Ed’s insurance company will indemnify Ed to the extent of its liability for Ed’s loss and then have the right to proceed against Dave for any amounts it has paid out under Ed’s policy.
Reasons for Subrogation
One of the important reasons for subrogation is to reinforce the principle of indemnity—that is, to prevent the insured from collecting more than the actual amount of the loss. If Cameron’s insurer did not have the right of subrogation, it would be possible for Cameron to recover from the policy and then recover again in a legal action against Randy. In this way Cameron would collect twice. It would also be possible for Cameron to arrange an accident with Randy, collect twice, and split the profit with Randy. A moral hazard would exist, and the contract would tend to become an instrument of fraud.
Another reason for subrogation is that it keeps insurance premiums below what they would otherwise be. In some lines of insurance, particularly liability, recoveries from negligent parties through subrogation are substantial. Although no specific provision for subrogation recoveries is made in the rate structure other than through those provisions relating to salvage, the rates would tend to be higher if such recoveries were not permitted. A final reason for subrogation is that the burden of loss is more nearly placed on the shoulders of those responsible. That is, the party that caused the loss is held financially accountable for its actions. Negligent parties should not escape penalty because of the insurance mechanism.
Exceptions to the Principle of Subrogation
Subrogation normally does not exist in such lines as life insurance. Also, subrogation does not give the insurer the right to collect against the insured, even if the insured is negligent. Thus, a homeowner who negligently, but accidentally, burns down the house while thawing a frozen water pipe with a blowtorch can collect under a fire policy, but the insurer cannot proceed against the owner of the policy for compensation. Otherwise, there would be little value in having insurance.
It is not uncommon for an insurer to waive rights of subrogation under certain circumstances where, by so doing, there is no violation of the principle of indemnity. Suppose that a manufacturer has agreed to hold a railroad harmless for losses arising out of the maintenance of a spur track that the railroad has placed on the manufacturer’s property. In effect, the manufacturer has assumed legal liability that would otherwise be the responsibility of the railroad. Now assume that a spark from one of the railroad’s engines sets fire to the manufacturer’s building and the railroad is found negligent, and hence legally liable for the ensuing damage. The insurer will pay the loss, but under its right of subrogation could proceed against the railroad. However, the manufacturer has previously agreed to assume all losses arising out of the existence of the spur track. Thus, any amount collected from the railroad becomes the ultimate liability of the manufacturer because of the hold-harmless agreement. Therefore, the insurer will waive the subrogation clause in the manufacturer’s insurance policy because to enforce it would mean that the insured would not be compensated for its loss. This waiver can be performed by inserting a waiver-of-subrogation clause in the manufacturer’s insurance policy. Such clauses are common.
An insured who acts in such a way as to destroy or reduce the value of the insurer’s right of subrogation violates the provisions of most subrogation clauses and forfeits all rights under the policy. For instance, suppose Fred collides with Gladys in an automobile accident. Fred writes Gladys a letter of apology and implies that he is to blame. It is later determined that Gladys is probably negligent and, had it not been for Fred’s statement, his insurer would have been able to subrogate against Gladys for the amount paid to Fred. Consequently, the insurer may deny liability to Fred. The insurer’s subrogation rights also cannot be avoided by a settlement between the primary parties after the insurer has paid under the policy. In such a case, the insurer is entitled to reimbursement from the insured who has received any payment from the negligent party.
Finally, note that the insurer is entitled to subrogation only after the insured has been fully indemnified. If the insured has borne part of the loss (perhaps due to inadequate coverage), the insurer may claim recovery only after these costs have been repaid. The only exception to this rule is that the insurer is entitled to legal expenses incurred in pursuing the subrogation process against a negligent third party. For example, assume that Query Company’s building, valued at $200,000 and insured for $160,000, is totally destroyed through the negligence of contractor James Forehand. Query’s insurer subrogates against Forehand and collects $100,000 and has legal expenses of $25,000. The insurer receives $25,000 for legal expenses, Query receives the $40,000 by which he was underinsured, and the insurer receives the remaining $35,000.
Which of the following is a reason for subrogation in insurance policies?
it allows the insured to collect twice for a loss caused by someone else
it reduces the premium that would otherwise have to be charged in the absence of a subrogation provision
in liability insurance, it doesn't require the person responsible for a loss to pay the cost of a loss
The interaction between the subrogation clause and the need to waive subrogation rights can raise interesting ethical issues for insurers and insureds, even when no specific waiver-of-subrogation clause exists in an insurance policy. Consider the case of an insured who owned property, of which a portion was leased to another individual, named Polk. As part of the lease agreement, there was a waiver excusing Polk from liability for destruction of the property by fire.
On a date within the insured’s policy period, the property was destroyed by a fire. The insured made a claim for recovery of the damages from the insurer. After an investigation of the blaze, the insurer determined that the damages were caused as a direct result of Polk’s negligence. Thus, the insurer paid the amount of the damages to the insured and then started proceedings against Polk to recover (subrogate) for the damages because of Polk’s alleged negligence. Polk defended on the grounds that the contract between Polk and the insurer constituted a waiver-of-subrogation clause.
Polk won. The court held that the owner’s fire insurer was not entitled to subrogation against Polk for the fire loss paid to the owner. The insurer’s right to subrogation could not extend beyond the insured’s own rights, and the lease agreement limited the ability to subrogate for fire losses. Thus, because the owner had no rights to collect from Polk, the insurer had no subrogation rights against him either.
Sources: Continental Casualty Company, et al. v Polk Brothers, Inc., Illinois Appellate Court (November 21, 1983); Insurance Law Reporter (Commerce Clearing House, 1985): 980–86.
PRINCIPLE OF UTMOST GOOD FAITH
Insurance is said to be a contract of utmost good faith, in which a higher standard of honesty is imposed on parties to an insurance agreement than is imposed through ordinary commercial contracts. The principle of utmost good faith has greatly affected insurance practices and casts a very different light on the interpretation of insurance agreements than many persons often suppose. The application of this principle may best be explained in a discussion of representations, warranties, concealments, and mistakes.
A representation is a statement made by an applicant for insurance before the policy is issued. Although the representation need not be in writing, it is usually embodied in a written application. An example of a representation in life insurance would be answering yes or no to a question as to whether or not the applicant had been treated for any physical condition or illness by a doctor within the previous five years. If a representation is relied on by the insurer in entering into the contract and if it proves to have been false at the time it was made or becomes false before the contract is signed, there exist legal grounds for the insurer to avoid the contract.
Avoiding the contract does not follow unless the misrepresentation is material to the risk—that is, if the truth had been known, the contract either would not have been issued or would have been issued on different terms. If the misrepresentation is inconsequential, its falsity will not affect the contract. However, a misrepresentation of a material fact may make the contract voidable, at the option of the insurer. The insurer may decide to affirm the contract or to avoid it. Failure to cancel a contract after first learning about the falsity of a material misrepresentation may operate to defeat the insurer’s rights to cancel at a later time.
Generally, even an innocent misrepresentation of a material fact is no defense for the insured if the insurer elects to avoid the contract. Applicants for insurance speak at their own risk, and if they make an innocent mistake about a fact they believe to be true, they are held accountable for their carelessness. Thus, suppose Cassandra Cole applies for insurance on her automobile and states that there is no driver under age 25 in her family. However, it turns out that her 16- year-old son has been driving the family car without his mother’s knowledge. Lack of this knowledge is no defense when the insurance company refuses to pay a subsequent claim on the grounds of material misrepresentation. It is not necessary for the insurer to demonstrate that a loss occurred arising out of the misrepresentation in order to exert its right to avoid the contract. Thus, in the preceding case, assume Cassandra has an accident and it is then learned for the first time that she has a 16-year-old son driving. Since this situation is contrary to that which Cassandra had previously stated, the insurer may usually legally refuse payment.
If the court holds that a statement given in the application was one of opinion, rather than fact, and it turns out that the opinion was wrong, it is necessary for the insurer to demonstrate bad faith or fraudulent intent on the part of the insured in order to avoid the contract. For example, Jeff Meyers is applying for health insurance. He is asked on the application form, “Have you ever had cancer?” and he answers no. Later he discovers that he actually had cancer. The court might well find that the insured was not told the true state of his health and thought that he had some other ailment. If the question had been phrased, “Have you ever been told you had cancer?” a yes or no answer would clearly be one of fact, not opinion. An honest opinion should not be grounds for rescinding an insurance policy.
A warranty is a clause in an insurance contract stating that before the insurer is liable, a certain fact, condition, or circumstance affecting the risk must exist. For example, an insurance policy covering a ship may state “warranted free of capture or seizure.” This statement means that if the ship is involved in a war skirmish, the insurance is void. Or a bank may be insured on condition that a certain burglar alarm system be installed and maintained. Such a clause is a condition of coverage and acts as a warranty. A warranty creates a condition of the contract, and any breach of warranty, even if immaterial, will void the contract. This is the central distinction between a warranty and a representation. A misrepresentation does not void the insurance unless it is material to the risk, whereas under common law any breach of warranty, even if deemed to be minor, voids the contract. The courts have been somewhat reluctant to enforce this rule, and in many jurisdictions the rule has been relaxed either by statute or by court decision.
Warranties may be either express or implied. Express warranties are those stated in the contract, whereas implied warranties are not found in the contract but are assumed by the parties to the contract. Implied warranties are found in policies covering ocean vessels. For example, a shipper purchases insurance under the implied condition that the ship is seaworthy, that the voyage is legal, and that there shall be no deviation from the intended course. Unless these conditions have been waived by the insurer (legality cannot be waived), they are binding on the shipper. A warranty also may be either promissory or affirmative. A promissory warranty describes a condition, fact, or circumstance to which the insured agrees to be held during the life of the contract. An affirmative warranty is one that must exist only at the time the contract is first put into effect. For example, an insured may warrant that a certain ship left port under convoy (affirmative warranty), and the insured may warrant that the ship will continue to sail under convoy (promissory warranty).
A concealment is defined as silence when obligated to speak. A concealment has approximately the same legal effect as a misrepresentation of a material fact. It is the failure of an applicant to reveal a fact that is material to the risk. Because insurance is a contract of utmost good faith, it is not enough that the applicant answer truthfully all questions asked by the insurer before the contract is effected. The applicant must also volunteer material facts, even if disclosure of such facts might result in rejection of the application or the payment of a higher premium.
The applicant is often in a position to know material facts about the risk that the insurer does not. To allow these facts to be concealed would be unfair to the insurer. After all, the insurer does not ask questions such as “Is your building now on fire?” or “Is your car now wrecked?” The most relentless opponent of an insurer’s defense suit would not argue that an insured who obtained coverage under such circumstances would be exercising even elementary fairness.
The important, often crucial, question about concealments lies in whether or not the applicant knew the fact withheld to be material. The tests of a concealment are as follows:
- Did the insured know of a certain fact?
- Was this fact material?
- Was the insurer ignorant of the fact?
- Did the insured know the insurer was ignorant of the fact?
The test of materiality is especially difficult because often the applicant is not an insurance expert and is not expected to know the full significance of every fact that might be of vital concern to the insurer. The final determination of materiality is the same as it is in the law of representation, namely, would the contract be issued on the same terms if the concealed fact had been known? There are two rules determining the standard of care required of the applicant. The stricter rule, which usually applies only to ocean vessels and their cargoes, holds that intentional concealment as well as innocent concealment can void the contract. In this case, the fourth test for concealment is irrelevant. For most other risks, however, the rule is that a policy cannot be avoided unless there is fraudulent intent to conceal material facts. Thus, the intentional withholding of material facts with intent to deceive constitutes fraud. In determining which facts must be disclosed if known, it has been held that facts of general knowledge or facts known by the insurer need not be disclosed. There is also the inference from past cases, though not a final determination, that the insurer cannot void a contract on the grounds of concealment of those facts that are embarrassing or self-disgracing to the applicant.
When an honest mistake is made in a written contract of insurance, steps can be taken to correct it after the policy is issued. Generally, a policy can be reformed if there is proof of a mutual mistake or a mistake on one side that is known to be a mistake by the other party, where no mention was made of it at the time the agreement was made. A mistake in the sense used here does not mean an error in judgment by one party but refers to a situation where it can be shown that the actual agreement made was not the one stated in the contract.
As an illustration of this, consider an insurer that issued a $10,000 life insurance policy and, by an error of one of its clerks, included an option at the end of 20 years to receive income payments of $1,051 per year, rather than $105.10 per year. The mistake was discovered 18 years later. When the insurer tried to correct the error, the insured refused to accept payment of the smaller amount. In a legal decision, the court held that the mistake was a mutual one that should be corrected. The error of the insurer was in misplacing a decimal point, whereas the error of the insured was either in not noticing the error or, if noticed, in failing to say anything. Thus, the correct, smaller payment was substituted for the larger, incorrect one stated in the policy.2
In contrast to the previous example, suppose Adam believes himself to be the owner of certain property and insures it. He cannot later demand all of the premium back solely because he discovers that, in fact, he was not the owner of the property. This was a mistake in judgment or an erroneous supposition, and the courts will not relieve that kind of mistake.
REQUISITES OF INSURABLE RISKS
In spite of the usefulness of insurance in many contexts, not all risks are commercially insurable. The characteristics of risks that make it feasible for private insurers to offer insurance for them are called the requisites of insurable risks. These requirements should not be considered as absolute, iron rules but rather as guides or ideal standards that are not always completely attained in practice. Even when their absence makes it impossible for insurance to be offered by private insurers, however, government agencies may offer some protection. The principles of this “social insurance” are discussed later in this chapter.
Large Number of Similar Exposure Units
One of the most important requirements from the standpoint of the insurer is that the probable loss must be subject to advance estimation, which means that the number of insured exposures must be sufficiently large and that the exposures themselves must be similar enough to allow the law of large numbers to operate. If only a few expsoures are insured, the insurer is subject to the same uncertainties as the insured. The field of life insurance is one in which this requisite is satisfied particularly well. Life insurers have gathered reliable statistics over many years and have developed tables of mortality that have proved to be very accurate as estimates of probable loss. Furthermore, life insurance is well accepted; it is relatively easy for the insurer to obtain a large group of exposure units. Here the law of large numbers works so well that for all practical purposes the life insurer is able to eliminate its risk. On the other hand, insurers may not be able to predict losses nearly so well in areas such as nuclear energy liability and physical loss to ocean-based drilling platforms, where adequate numbers of exposures may be lacking.
In addition to having a sufficiently large number of insured exposures, the nature of the exposures must be enough alike so that reliable statistics on loss can be formulated. It would be improper, for example, to group commercial buildings with private residences for purposes of fire insurance, because the hazards facing these classes of buildings are entirely different. Furthermore, the physical and social environment of all exposures in the group should be roughly similar so that no unusual factors are present that would cause losses to one part of the group and not to the other part. Thus, buildings located in a hurricane zone must not be grouped with buildings a thousand miles from the coast.
It should also be noted that sometimes insurers act as risk transferees even when it is impossible to obtain a sufficiently large number of exposure units to allow the law of large numbers to operate. In these situations, risk is not reduced as part of the transfer, and the insurer should be thought of merely as a transferee for such transactions.
Accidental and Unintentional Loss
There must be some uncertainty surrounding the loss. Otherwise, there would be no risk. If the risk or uncertainty has already been eliminated, insurance serves no purpose; the main function of insurance is to reduce risk. Thus, if a key employee is dying from an incurable disease that will cause death within a given time, there is little uncertainty or risk concerning the payment of loss. Thus, insurance is not feasible. Theoretically, the insurer could issue a policy, but the premium would have to be large enough to cover both the expected loss and the insurer’s cost of doing business. The cost of such a policy would probably be too high for the prospective insured.
Because of the requirement that the loss be accidental, insurers normally exclude in all policies any loss caused intentionally by the insured. If the insured knew that the insurer would pay for intentional losses, a moral hazard would be introduced, causing both losses and premiums to rise. If premiums become exceedingly high, few would purchase insurance, and the insurer would no longer have a sufficiently large number of exposure units to be able to obtain a reliable estimate of future losses. Thus the first requirement of an insurable risk would not be met.
Such a scenario is similar to the phenomenon of adverse selection, which is the tendency of insureds who know that they have a greater than average chance of loss to seek to purchase more than an average amount of insurance. When an insured possesses knowledge about likely losses that is unavailable to insurers, the insured is said to have asymmetric information. The existence of asymmetric information is one cause of adverse selection. In general, insurers try to control adverse selection by investigating potential insureds and then providing coverage only to those who meet specified standards. This process of selecting and classifying insureds from among the many applicants is called underwriting and is discussed in Chapter 19.
To illustrate the unfortunate effects that adverse selection would cause if insurers did not practice underwriting, consider the example of crime insurance. Businesses operating in high-crime areas are the ones most likely to want to buy crime insurance, even at a premium that is too high to be attractive to firms in safer locations. If an insurer does not engage in some degree of underwriting, it may find itself selling primarily to very high-risk firms. Subsequent loss payments will be more than expected, and premiums will have to be increased. As premiums increase, fewer businesses will be interested in the insurance, and the only ones who will ultimately find the protection economically attractive will be those with a very high chance of loss. At this point, the insurance arrangement may be said to have entered a “death spiral,” in which it will eventually fail due to the lack of several of the necessary requisites.
Determinable and Measurable Loss
The loss must be definite in time and place. It may seem unnecessary to add this requirement because most losses are easily recognized and can be measured with reasonable accuracy. It is a real problem to insurers, however, to be able even to recognize certain losses, let alone measure them. For example, an insurer may agree to pay the insured a monthly income if the individual should become so totally disabled as to be unable to perform the duties of his or her occupation. The question arises, however, as to who will determine whether or not the insured meets this condition. Often it is necessary to take the insured’s word. Thus, it may be possible for a dishonest person to feign illness in order to recover under the policy. If this happens, the second requirement, that the loss is not intentional, is not met.
Even if it is clear that a loss has occurred, it may not be easy to measure it. For example, what is the loss from “pain and suffering” of an auto accident victim? Often only a jury can decide. What is the loss of a cargo on a sunken ship? It often takes a staff of adjusters many months or even years to decide. Thus, before the burden of risk can be safely assumed, the insurer must set up procedures to determine whether loss has actually occurred and, if so, its size.
Loss Not Subject to Catastrophic Hazard
Conditions should not be such that all or most of the objects in the insured group might suffer loss at the same time and possibly from the same peril. Such simultaneous disaster to insured objects can be illustrated by reference to large fires, floods, earthquakes, and hurricanes that have disrupted major geographical areas in the past. In 1992, insurers doing business in south Florida were reminded of this possibility when Hurricane Andrew struck, resulting in widespread damage for hundreds of thousands of insureds across the state. The history of fire insurance reveals that very few major U.S. cities have escaped suffering a catastrophic fire at some time in their history. One example from the early 1900s is San Francisco, which was nearly destroyed by an earthquake and the fires that resulted. If an insurer is unlucky enough to have on its books a great deal of property situated in areas such as these when catastrophe occurs, it obviously suffers a loss that was not contemplated when the premiums were formulated. Most insurers reduce this possibility by ample dispersion of insured objects. It is also possible for insurers themselves to purchase insurance against the possibility of excessive losses. This insurance for insurers is called reinsurance and is discussed in greater detail in Chapter 19. Following the September 11 terrorist attacks many firms had difficulty obtaining insurance for so-called trophy properties due to the recognition by insurers of the catastrophic loss potential associated with these buildings. This situation was made worse by the lack of reinsurance for such properties.
This requisite concerning the absence of a catastrophic hazard also effectively eliminates many speculative risks from the possibility of being insured. For example, consider the uncertainty that a retailer faces in connection with the price at which inventories can be sold. Suppose it wishes to insure that the price of its product will not fall more than 10 percent during the year. Such a risk is subject to catastrophic loss because simultaneous loss from this source is possible to all products. Further, the losses are not subject to advance calculation because, in an ever-changing, competitive market, past experience is an inadequate guide to the future. Hence, the insurer would have no realistic basis for computing a premium. Furthermore, in times of rising prices, few would be interested in the coverage, and in times of falling prices, no insurer could afford to take on the risk. The insurer could get no “spread of risks” over which to average out good years with bad years.
Although an insurer theoretically might be willing to provide insurance regardless of the potential size of a particular loss, a requisite from the standpoint of the insured is that the maximum possible loss must be relatively large. The large-loss principle states that businesses and individuals should insure potentially serious losses before relatively minor losses. To do otherwise is uneconomical because small losses tend to occur frequently and are very costly to recover through insurance. If one can pay for a loss from savings or current income, it is probably too small a loss to give insurance high priority as a method of risk treatment.
As an example, suppose there is a 2 percent probability that a collision will completely destroy a $20,000 car owned by QPC Corporation. QPC may realize that the expected value of such a loss is 0.02 × $20,000, or $400. Yet collision insurance might cost $750 because the insurer must charge enough to pay for all expected losses plus the cost of doing business. Should QPC buy the insurance? If a $20,000 automobile represents a large portion of QPC’s total assets, insurance may be purchased. But if the car is one of a large fleet and represents only a small fraction of total assets, the purchase of insurance is unlikely.
Probability of Loss Must Not Be Too High
The final requisite of an insurable risk is that the probability of loss must be reasonable, or else the cost of risk transfer will be excessive. This requisite is of concern primarily for the potential insured, rather than the insurer. Due to the element of risk, insureds are often willing to pay more to avoid a loss than the true expected value of that loss. If fact, if it were not for this phenomenon, insurance could not exist, for insurers must always charge more for their service than the expected value of a loss. But the more probable the loss, the greater the premium will be. And a point ultimately is reached when the loss becomes so likely that when the insurer’s expenses are added on, the cost of the premium becomes approaches or even exceeds the full value of the item insured. At this point, insurance is no longer feasible because the insured will not be willing to pay the necessary premium. Three illustrations of the application of this requisite are included in Table 5-1, which also summarizes the extent to which other requisites are present for the three risks illustrated.
Of the following requisites of an insurable, which one is the most important in explaining why life insurance policies are usually not available for issue above a certain age (such as 95)?
accidental and unintentional
determinable and measurable
probability of loss not too high
REQUIREMENTS OF AN INSURANCE CONTRACT
A contract is an agreement embodying a set of promises that are legally enforceable. These promises must have been made under certain conditions before they can be enforced by law. Insurance policies are contracts and, as such, must comply with the elements required of all valid contracts.
Requirements of All Valid Contracts
In general, there are four requirements that are common to all valid contracts:
- Agreement must be for a legal purpose. For insurance policies, this requirement means that the contract must neither violate the requirement of insurable interest nor protect or encourage illegal ventures.
- Parties must have legal capacity to contract. Parties who have no legal capacity to contract include insane persons who cannot understand the nature of the agreement; intoxicated persons; corporations acting outside the scope of their charters, bylaws, or articles of incorporation; and minors. Some states make exceptions for the last category, under which minors who have reached a certain age (for example, 141⁄2 years) are granted the power to make binding contracts of insurance.
- There must be a valid offer and acceptance. The general rule in insurance is that it is the applicant for insurance, not the agent, who makes the offer. The agent merely solicits an offer. When the contract goes into effect depends on the authority of the agent to act for the insurer in a given case. In property and liability insurance, it is the custom to give local agents authority to accept offers of many lines of insurance on the spot. In such cases, it is said that the agent will bind the insurer. If the insurer wishes to escape from its agreement, it may usually cancel the policy upon prescribed notice. In life insurance, the agent generally does not have authority to accept the applicant’s offer for insurance. The insurer reserves this right, and the policy is not bound until the insurer has accepted the application. If the insurer wishes to alter the terms of the proposed contract, it may do so, and this is construed as making a counteroffer to the applicant, who may then accept or reject it. A legal offer by an applicant for life insurance must be supported by a tender of the first premium. Usually, the agent gives the insured a conditional receipt that provides that acceptance takes place when the insurability of the applicant has been determined. Let us say that Todd Ichihara applies for life insurance, tenders an annual premium with the application, receives a conditional receipt, passes the medical examination, and then is run over and killed by a truck, all before the insurer is even aware that an application has been made for insurance. Todd’s beneficiaries may collect under the policy if it is determined that Todd was actually insurable at the time of the application and had made no false statements in the application. An applicant for life insurance who does not pay the first annual premium in advance has not made a valid offer. In this case, the insurer’s agent transmits the application to the home office, where it is processed and questions of insurability are determined. The insurer sends the policy back to the agent for delivery, and the agent is instructed to deliver (offer) the policy only if the insured is still in good health. The offer can be accepted by paying the annual premium at the time of delivery.
- Promises must be supported by the exchange of consideration. A consideration is the value given to each contracting party. The insured’s consideration is made up of the monetary amount paid in premiums, plus an agreement to abide by the conditions of the insurance contract. The insurer’s consideration is its promise to indemnify upon the occurrence of loss due to certain perils, to defend the insured in legal actions, or to perform other activities such as inspection or collection services, as the contract may specify.
DISTINGUISHING CHARACTERISTICS OF INSURANCE CONTRACTS
In addition to the general requirements for all valid contracts, insurance contracts and their issuing parties have several characteristics that distinguish them from other contracts and contracting parties.
Insurance is classified as an aleatory contract, in which the values exchanged by the contracting parties are not necessarily equal. This characteristic is due to the fact that the outcome of the contract depends on the risk of whether or not a loss will occur. If a loss does take place during the policy period, then the amount paid by the insurer usually will exceed the premium paid by the insured. If no loss occurs, then the premium exceeds the amount paid by the insurer. But even though the insurance policy itself is aleatory, the entire book of business written by the insurer is anything but aleatory, because premiums are calculated to be sufficient to pay all expected claims.
Insurance is classified as a conditional contract because insureds must perform certain acts if recovery is to be made. If the insured does not adhere to the conditions of the contract, payment is not made even though an insured peril causes a loss. Typical conditions include payment of premium, providing adequate proof of loss, and giving immediate notice to the insurer of a loss. Thus, the conditions are a part of the bargain.
Contract of Adhesion
The insurance contract is said to be a contract of adhesion, meaning that any ambiguities or uncertainties in the wording of the agreement will be construed against the drafter—the insurer. This principle is due to the fact that the insurer had the advantage of writing the terms of the contract to suit its particular purposes. And in general, the insured has no opportunity to bargain over conditions, stipulations, exclusions, and the like. Therefore, the courts place the insurer under a legal duty to be explicit and to make its meaning absolutely clear to all parties. In interpreting the agreement, the courts will generally consider the entire contract as a whole, rather than just one part of it. In the absence of doubt as to meaning, the courts will enforce the contract as it is written. It is no excuse that the insured does not understand or has not read the policy.
An extension of the concept of adhesion is the doctrine of reasonable expectations, which goes further than just saying that ambiguities should be decided in favor of the insured. The doctrine provides that coverage should be interpreted to be what the insured can reasonably expect. Limitations and exclusions must be clear and conspicuous. An example of this doctrine is illustrated by the case of an insured’s policy that provided for burglary protection only when the building was open. But the literature used to sell the insurance referred to all-risk or comprehensive crime protection and included a picture representing a burglary after a building was closed. The insured’s claim resulted from a burglary loss after the building was closed and was denied by the insurer. But the courts ruled that the insured had a reasonable expectation for coverage to apply and required the insurer to pay for the loss.
Insurance contract are often considered "contracts of adhesion" which means that unclear language or ambiguities in the contract will be construed or interpreted in favor of
the drafting party
Finally, an insurance policy is a unilateral contract, because only one of the parties makes promises that are legally enforceable. Insureds cannot be forced to pay premiums or adhere to conditions. Of course, if they do not do so, the conditional nature of the contract keeps them from being able to collect for insured losses. But if the insured does what has been promised, then the insurer is legally obligated to perform in the event of a covered loss.
ROLE OF AGENTS AND BROKERS
An agent is a person given power to act for a principal, who is legally bound by the acts of its authorized agents. The law recognizes two major classes of agents: general and special. A general agent is a person authorized to conduct all of the principal’s business of a given kind in a particular place. In contrast, a special agent is authorized to perform only a specific act or function. If anything occurs that is outside the scope of this authority, the agent must obtain special power to handle it. Thus, in a legal sense, insurance agents do not necessarily have to serve in the channel of distribution for insurance, although that is the most common use of the term insurance agent.
An insurance agent should be assumed to be the legal agent of the insurer, unless information to the contrary is known. In contrast, an insurance broker is the legal agent of the prospective insured and is engaged to arrange insurance coverage on the best possible terms. The broker has contacts with many insurers but may not have an agency agreement with them. Thus, a broker is free to deal with any insurer that will accept the business. The broker cannot bind any insurer orally to a risk unless the broker has an agency agreement with the insurer. Thus, in dealing with a broker, one should not assume coverage the moment the insurance is ordered. One is covered only when the broker contacts an insurer that agrees to accept the risk. The distinction between an agent and a broker is not always clear, because in some situations a person may simultaneously be both an agent and a broker. Typically, courts will construe the evidence in the light most favorable to the insured.
Authority of Agents and Brokers
The basic source of authority for all insurance agents (using the word agent in its broad sense) comes from stockholders or policyowners and is formulated by the charter, bylaws, and custom of a given insurer. For agents and brokers in the insurance distribution channel, there are two distinct sources of authority: the agency agreement and ratification. The agency agreement sets forth the specific duties, rights, and obligations of both the insurer and the agent. Unfortunately, the agreement is often inadequate as a complete instrument; hence, the agent may do something that the principal did not intend. This situation gives rise to the other method by which an agent may receive authority from the principal, known as ratification. If an agent performs some act outside the scope of the agency agreement to which the insurer later assents, then the agent has achieved additional authority through ratification. For example, suppose Wendy Wyatt sells an insurance policy covering a particular building against loss by fire. Wendy is not authorized to do this, but she later persuades insurer PGH to accept this risk. She thus becomes PGH’s agent by ratification.
Two other principles are important in understanding the law of agency. One of these is the concept of waiver, which is the intentional relinquishing of a known right. In contrast, estoppel operates when there has been no intentional relinquishing of a known right. Estoppel operates to defeat a “right” that a party technically possesses. Waiver is based on consent, whereas estoppel is an imposed liability. Often these two doctrines are not clearly distinguished even in court actions, and sometimes they are used interchangeably. They are of interest primarily in understanding how the acts of insurance agents may or may not be binding on insurers.
Waiver and estoppel situations often arise when the insurance policy is first put into force. Suppose an agent writes a fire insurance policy with the full knowledge that some condition in the policy is breached at the time it is issued. For example, the insured might be engaged in a type of business that the insurer has instructed its agents not to cover and has excluded in the policy. The agent issues the policy anyway, and there is a loss before the insurer has had an opportunity to cancel the contract. Most courts would say that the action by the agent constituted an acceptance of the breached condition, and the insurer would be estopped from denying payment of the claim.
PRINCIPLES OF SOCIAL INSURANCE
Social insurance is offered through some form of government, usually on a compulsory basis. It is designed to benefit persons whose incomes are interrupted by an economic or social condition that society as a whole finds undesirable and for which a solution is generally beyond the control of the individual. Social insurance plans are usually introduced when a social problem exists that requires government action for solution and where the insurance method is deemed most appropriate. Examples are the problems of crime, poverty, unemployment, mental disease, ill health, dependency of children or aged persons, drug addiction, industrial accidents, divorce, and economic privation of a certain class, such as agricultural workers. Insurance is not an appropriate method of solution for many of these problems because the peril is not accidental, fortuitous, or predictable. In other instances insurance is perhaps feasible, but due to the catastrophic nature of the event (as in unemployment), private insurers cannot undertake the underwriting task because of lack of financial capacity. This means that if the insurance method is to be used as a solution to certain problems, government agencies must either administer or finance the insurance plan. Following the September 11 attacks firms could not secure terrorism insurance in the private insurance market leading to calls for a government role in providing such coverage. Subsequently the federal government did become involved in providing a backstop for insurers offering terrorism coverage. Although the specific details of various social insurance programs are discussed in later chapters of this text, an understanding of social insurance can be facilitated by an appreciation of the basic differences between these and privately sponsored insurance devices.
Dive Deeper: Because of governmental involvement, most social insurance programs are subject to continual change. Check out the website of the National Academy of Social Insurance to explore current social insurance issues. Which of these issues do you consider to be the most important? Why? Do any of the current proposals violate the principles of social insurance? See those principles below.
Most social insurance plans are characterized by an element of compulsion. Because social insurance plans are designed to solve some social problem, it is necessary that everyone involved cooperate. This principle is in sharp contrast to private insurance, which has very few compulsory features.
Set Level of Benefits
In social insurance plans, little if any choice is usually given as to what level of benefits is provided. Further, all persons covered under the plan are subject to the same benefit schedules, which may vary according to the amount of average wage, length of service, or job status. In private, individual insurance, of course, one may usually buy any amount of coverage desired.
Benefits Not Based on Need
Social insurance is distinct from welfare. Unlike welfare, the right to receive social insurance benefits is generally not based on demonstrated financial need but rather based on the occurrence of certain events, such as turning a particular age. For example, even a billionaire becomes eligible for Medicare upon turning age 65.
Floor of Protection
A basic principle of social insurance in a system of private enterprise is that it aims to provide a minimum level of economic security against perils that may interrupt income. This principle, known as the floor-of-protection concept, is not always strictly observed, but it is still a fundamental theme of most social insurance coverage in the United States. The purpose of social insurance plans is to give all qualified persons a certain minimum protection, with the idea that more adequate protection can and should be provided through individual initiative. The incentive to help oneself, a vital element of the free-enterprise system, is thus preserved.
All insurance devices have an element of subsidy in that the losses of the unfortunate few are shared with the fortunate many who escape loss. In social insurance it is anticipated that an insured group may not pay its own way but will be subsidized either by other insured groups or by taxpayers. Some social insurance plans have access to general tax revenues if the contributions from covered workers are inadequate.
Unpredictability of Loss
For several reasons, the cost of benefits under social insurance cannot usually be predicted with great accuracy. Therefore, the cost of some types of social insurance is unstable. For example, in a general depression, unemployment may rise to unusual heights, causing tremendous outlays in benefits that may threaten the solvency of the unemployment compensation fund.
In social insurance programs, benefits are often conditional. For example, if one earns more than a specified amount, various social insurance benefits may be lost. One might argue that it is wrong to attach conditions to recovery in social insurance, under the theory that one should receive benefits as a matter of right. However, an insured worker has no particular inalienable right, except the right given by the social insurance law under which the worker is protected. The employee’s right can and probably should be conditional. To have it otherwise would mean that some would be receiving payments not really needed, and either the costs would rise or others would be deprived of income that is their sole source of support. One of the basic advantages of social insurance is this very flexibility, which permits those most in need to receive a greater relative share of income payments than others whose economic status is such that they do not require as much.
In order to qualify as social insurance, a public program should require a contribution, directly or indirectly, from the person covered, the employer, or both. Thus, social insurance does not include public assistance programs wherein the needy person receives outright gifts and must generally prove inability to pay for the costs involved. This does not mean that the beneficiary in social insurance must pay all of the costs, but the beneficiary must make some contribution or else the program is not really an insurance program but rather a form of public charity. For example, welfare payments to dependent children are not a form of social insurance, as the term is normally understood, although such payments are undoubtedly made to solve a social problem that could have been met by insurance.
Attachment to the Labor Force
Although it is not a necessary principle of social insurance, most social insurance plans cover only groups that are or have been attached to the labor force. The basic reason for this is that nearly all such plans are directed at those perils that interrupt income. Private insurance contracts, of course, are issued to individuals regardless of employment status. The requirement of attachment to the labor force has been a subject of frequent criticism by those who want a greater expansion of social insurance.
Minimal Advance Funding
In contrast to many forms of private insurance, social insurance usually does not provide large accumulations for advance funding. This means that if, for example, a future retirement benefit is promised, the full cost of paying for this benefit is not set aside in the year in which the promise is made. Instead, the benefit is paid from future revenues at the time the benefits must be paid out to the retiring worker. Full advance funding in social insurance programs is not necessary, and in fact is undesirable from an economic standpoint. To collect enough money currently to pay all the future benefits that are promised would require a huge increase in social insurance taxes, an action that could well produce a business depression. Advance funding is not necessary because social insurance programs are backed by the taxing power of government. Social insurance programs and the revenues to support them are expected to continue indefinitely and require no advance funding. In private insurance, on the other hand, advance funding is needed to guarantee future benefits to the insured. Private organizations have no guaranteed source of future revenues, and in fact may go completely out of business, leaving would-be beneficiaries stranded without effective recourse against the insurer.
SOCIAL AND ECONOMIC VALUES AND COSTS OF INSURANCE
It has been implied in the foregoing discussion that to distinguish between insurable and uninsurable risks serves a useful purpose. Insurance has peculiar advantages as a device to handle risk and so ought to be used to bring about the greatest economic advantage to society. To establish the validity of this point, some of the social and economic values and costs of insurance are contrasted in this section.
Social and Economic Values
Reduced Reserve Requirements
Perhaps the greatest social value—indeed, the central economic function—of insurance is to obtain the advantages that flow from the reduction of risk. One of the chief economic burdens of risk is the necessity of accumulating funds to meet possible losses, and one of the great advantages of the insurance mechanism is that it greatly reduces the total of such reserves necessary for a given economy. Because the insurer can predict losses in advance, it needs to keep readily available only enough funds to meet those losses and to cover expenses. If each insured had to set aside such funds, there would be need for a far greater amount. For example, in many localities, a $100,000 building can be insured against fire and other physical perils for about $500 a year. If insurance were not available, the insured would probably feel a need to set aside funds at a much higher rate than $500 a year.
Capital Freed for Investment
Another aspect of the advantage just described is the fact that the cash reserves that insurers accumulate are made available for investment. Insurers as a group, and life insurance firms in particular, are among the largest and most important institutions collecting and distributing the nation’s savings. From the viewpoint of the individual, the insurance mechanism enables renting an insurer’s assets to cover uncertain losses rather than providing this capital internally, much like renting a building instead of owning one. Capital that is thereby released frees funds for investment purposes. Thus, the insurance mechanism encourages new investment. For example, if an individual knows that his or her family will be protected by life insurance in the event of premature death, the insured may be more willing to invest savings in a long-desired project, such as a business venture, without feeling that the family is being robbed of its basic income security. In this way a better allocation of economic resources is achieved.
Reduced Cost of Capital
Because the supply of investable funds is greater than it would be without insurance, capital is available at a lower cost than would otherwise be possible. This result brings about a higher standard of living because increased investment itself will raise production and cause lower prices than would otherwise be the case. Also, because insurance is an efficient device to reduce risk, investors may be willing to enter fields they would otherwise reject as too risky. Thus, society benefits from increased services and new products, the hallmarks of increased living standards.
Reduced Credit Risk
Another advantage of insurance lies in its importance to credit. Insurance has been called the basis of the nation’s credit system. It follows logically that if insurance reduces the risk of loss from certain sources, it should mean that an entrepreneur is a better credit risk if adequate insurance is carried. Today it would be nearly impossible to borrow money for many business purposes without insurance protection that meets the requirements of the lender.
Loss Control Activities
Another social and economic value of insurance lies in its loss control or loss prevention activities. Although the main function of insurance is not to reduce loss but merely to spread losses among members of the insured group, insurers are nevertheless vitally interested in keeping losses at a minimum. Insurers know that if no effort is made in this regard, losses and premiums would have a tendency to rise. It is human nature to relax vigilance when it is known that the loss will be fully paid by the insurer. Furthermore, in any given year, a rise in loss payments reduces the profit to the insurer, and so loss prevention provides a direct avenue of increased profit.
A few illustrations of loss prevention and control in the field of property and liability insurance include (1) investigation of fraudulent insurance claims, (2) research into the causes of susceptibility to loss on highways, (3) recovery of stolen vehicles and other auto theft prevention work, (4) development of fire safety standards and public educational programs, (5) provision of leadership in the field of general safety, (6) provision of fire protection and engineering counsel for oil producers, and (7) investigation and testing of building materials to see that fire prevention standards are being met. In the life and health insurance industry, continuous support is given by private insurers to programs aimed at reducing loss by premature death, sickness, and accidents.
Business and Social Stability
Finally, the existence and availability of insurance can lead to increased business and social stability. Several illustrations may be helpful in envisioning this point. For example, if adequately protected, a business need not face the grim prospect of liquidation following a loss. Similarly, a family need not break up following the death or permanent disability of one or more income producers. A business venture can be continued without interruption even though a key person or the sole proprietor dies. A family need not lose its life savings following a bank failure. Old-age dependency can be avoided. Loss of a firm’s assets by theft can be reimbursed. Whole cities ruined by a hurricane can be rebuilt from the proceeds of insurance.
One of the chief economic burdens of risk is the necessity of accumulating funds to meet possible losses. If an individual owned a $20,000 car and the car could be insured against property damage for $400 per year, how much of a reserve fund would the owner likely feel he would need to accumulate if the insurance was not available?
more than $400
less than $400
the same amount as the premium ($400)
Social Costs of Insurance
No institution can operate without certain costs. The costs for an insurance institution include operating the insurance business, losses that are caused intentionally, and losses that are exaggerated.
Operating the Insurance Business
The main social cost of insurance lies in the use of economic resources, mainly labor, to operate the business. The average annual overhead of property insurers accounts for about 27 percent of their earned premiums but ranges widely, depending on the type of insurance. In life insurance an average of 17 percent of the premium dollar is absorbed in expenses. In other words, the advantages of insurance should be weighed against the cost of obtaining the service.
Losses That Are Intentionally Caused
A second social cost of insurance is attributed to the fact that if it were not for insurance, certain losses would not occur—losses that are caused intentionally by people in order to collect on their policies. Insurers are well aware of this danger, however, and take numerous steps to keep it to a minimum.
Losses That Are Exaggerated
Related to the cost of intentional losses is the tendency of some insureds to exaggerate the extent of damage that results from purely unintentional losses. For example, Company RRR has an old photocopy machine that does not work well. When a small fire in RRR’s building causes some smoke damage throughout the building, RRR may be tempted to claim that its fire insurance should pay for a new photocopy machine. The old machine likely has been affected by smoke, but in reality the machine did not work well before the fire and probably would have been replaced soon anyway. The existence of insurance tempts RRR to exaggerate its loss in this situation. Similarly, health expenses for families that have health insurance may be higher than the expenses for uninsured families. Once an accident or sickness has occurred, an individual may decide to undergo more expensive medical treatment, or the physician may prescribe it if it is known that an insurer will bear most or all of the cost.
1. Insurance reduces risk by combining under one management a group of objects situated so that the aggregate losses to which the insureds are subject become predictable within narrow limits. Losses that result are shared among the insureds, usually through the payment of an insurance premium.
2. The principle of insurable interest is necessary for an insurance contract to be valid. The principles of indemnity and subrogation reinforce the principle of insurable interest.
3. Because insurance is a contract of utmost good faith, breach of warranty or a material misrepresentation on the part of the insured can void the coverage. A concealment has the same legal effect as a material misrepresentation.
4. An insurance contract must not be against public policy, must be enacted by parties with legal capacity to contract, must be effected through a valid offer and acceptance, and must be supported by a monetary consideration. Insurance is a contract of adhesion, and any ambiguities are construed against the insurer. Insurance policies are also aleatory, conditional, and unilateral.
5. Insurance is effected through agents who have varying degrees of authority, depending on the custom in different lines of insurance and on the doctrines of waiver and estoppel. Brokers are agents of the insured.
6. From the standpoint of the insurer, there are four requisites of insurable risk: (a) there must be a sufficient number of similar insured objects to allow a reasonably close calculation of probable future losses, (b) the loss must be accidental and unintentional in nature, (c) the loss must be capable of being determined and measured, and (d) the exposure units must not be subject to simultaneous destruction.
7. From the viewpoint of the insured, there are two main requirements of insurability: (a) the loss must be severe enough to warrant protection and (b) the probability of loss should not be so high as to command a prohibitive premium when compared with the possible size of the loss.
8. In contrast to private insurance, social insurance (a) is compulsory, (b) does not allow individual choice in selecting the amount of benefit, (c) provides only a minimum level of benefit, (d) is subsidized by groups other than the insured group, (e) has a total cost that is often unpredictable, (f) covers only individuals who have been attached to the labor force and who meet certain minimum requirements, and (g) offers conditional benefits.
9. There are many social and economic values of insurance, but perhaps the greatest value lies in the reduction of risk in society. The benefits of insurance are achieved at certain social costs, the chief of which is the cost of the economic resources used to operate the insurance business.
 Metropolitan Life Insurance Co. v Henriksen, 126 N.E. (2d) 736 (Illinois Appellate Court, 1955).