Insurance – A Major and Complex Financial Service © Simon Horsman 2010

Relevant to Personal Financial Planning, an investment opportunity and a business.

Per http://en.wikipedia.org/wiki/Insurance - the which is more risky.

main source of the notes below. Debbie
Harrison (Chapter 7, on “Protection Insurance”, 4. The loss potential to the insurer must be
which you need to master, is excellent within its non-catastrophic, i.e., it cannot put the
limits,) focuses mainly on protection insurance. insurance company in financial jeopardy.
Losses must be uncertain of occurrence.
Insurance has a long history – in various forms it The rate and distribution of losses must be
can be traced back 5,000 years (e.g. in China). predictable. To set premiums, insurers must
It relies on what economists identify as the be able to predict losses accurately. This is
changing utility of money; i.e. that a loss of £X done using the law of large numbers, which
can be so painful that it’s worth paying a sum states that the larger the number of
greater than the expected value of £X to avoid homogenous exposures considered, the more
it. That margin is required to cover the costs of closely the losses reported will equal the
the associated processes and to provide profits underlying probability of loss. The expertise in
to draw entrepreneurs into this business. this area has given rise to the profession of
actuary. It also requires the insured to tell
Insurance is so complex that it has developed a the whole truth before any contract is struck
network of rules and conventions. The imbalance – uberrimae fidei.
of power between the parties is such that
governments usually impose various laws to If the coverage is unique, the insured will pay
regulate the situation. As the insurance a correspondingly higher premium. Lloyd's of
industry is essentially a network of contracts, London, for instance, often accepts unique
it’s impossible to imagine insurance existing coverages (e.g., the insuring of the finding of
without the prior “rule of law”. the Loch Ness Monster, Tina Turner's legs and
Jennifer Lopez's buttocks).
Insurance, in law and economics, is a form of
risk management primarily used to hedge The loss must not be catastrophic: If the
against the risk of a contingent loss. And it’s insurer is insolvent, it will be unable to pay the
available to all parties, citizens, business and insured. In the UK, the Financial Services
governments, Authority (FSA), which regulates all insurance
companies, has its own standards of solvency
Insurance is defined as the equitable transfer which are legally required to be adhered to.
of the risk of a potential loss, from one entity
(the insured) to another (the insurer), in To avoid catastrophic depletion of their own
exchange for a premium and duty of care. capital, insurers almost universally purchase
reinsurance to protect them against
Principles of Insurance excessively large accumulations of risk in a
From the point of view of the insurer (normally single area, and to protect them against large-
a company) there are four general criteria for scale catastrophes. This hardly affects
deciding whether to insure events or not. domestic insurance (home, theft, auto, life) as
you have large numbers of independent events,
1. There must be such a number of similar none of which are material from the viewpoint
objects but behaving independently, that the of the market as a whole. To research this
financial outcome of insuring a pool of follow the case of the EXXON Valdez,
exposures is predictable. Therefore they can http://en.wikipedia.org/wiki/Exxon_Valdez_oil_spill
calculate a "fair" premium.
Additionally, “speculative risks” like those
2. The losses have to be accidental and incurred through gambling or through the
unintentional (i.e., on the insured's part). purchase of company stock are uninsurable.
Of course this is where alternative responses
3. The losses must be measurable, identifiable to risk management have sprung up; for
in location and time, and definite. An insurer decades we have had the options market where
also requires that losses cause economic you can buy/sell call or put options and for
hardship. This so that the insured has an many years now spread betting
incentive to protect and preserve the property http://www.igindex.co.uk/spread-
and to minimize the probability that the losses betting/shares.html

occur. “Moral hazard” is the term given to the

possibility that being freed from part of a risk Insurable risks should have accidental and not
will encourage the insured towards behaviour intentional losses, and they should have

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economically feasible premiums, meaning that out less in claims and expenses than it receives
chance of loss must not be too high. in premiums and investment income) and some
are losers (i.e., the insurer pays out more in
When insured parties experience a loss for one claims and expenses than it receives in
of the specified perils, the coverage entitles premiums and investment income).
the policyholder to make a 'claim' against the
insurer for the covered amount of loss as An insurer's underwriting performance is
specified by the policy. The fee paid by the measured in its combined ratio. The loss ratio
insured to the insurer for assuming the risk is (incurred losses and loss-adjustment expenses
called the 'premium' which premiums are used divided by net earned premium) is added to
to fund accounts reserved for later payment the expense ratio (underwriting expenses
of claims - in theory for a relatively few divided by net premium written) to determine
claimants - and for overhead costs. the company's combined ratio. The combined
So long as an insurer maintains adequate funds ratio is a reflection of the company's overall
set aside for anticipated losses (i.e., reserves), underwriting profitability. A combined ratio of
the remaining margin is an insurer's profit. less than 100 percent indicates profitability,
while anything over 100 indicates a loss.
Insurer’s business model Insurance companies also earn investment
Insurers make money in two ways: profits on “float”. “Float” or available reserve
1. through underwriting, the process by is the amount of money, at hand at any given
which insurers select the risks to moment, that an insurer has collected in
insure and decide how much in insurance premium but has not been paid out in
premiums to charge for accepting claims. Insurers invest insurance premium
those risks and monies as soon as they are received and keep
2. by investing the premiums they collect earning returns until claims are paid out.
from the insured.
For example, in the US in the five years ending
The most difficult aspect of the insurance 2003, the underwriting loss of property and
business is the underwriting of policies. Using casualty insurance companies was $142.3
all the relevant data they can get their hands billion. But overall profit for the same period
on, insurers predict the likelihood that a claim was $68.4 billion, as the result of float.
will be made against their policies and price Some insurance industry insiders, most notably
their insurance products accordingly. To this Hank Greenberg, do not believe that it is
end, insurers use actuarial science to quantify forever possible to sustain a profit from float
the risks they are willing to assume and the without an underwriting profit as well, but this
premium they will charge to assume them. opinion is not universally held. Naturally, the
Actuarial science uses statistics and “float” method is difficult to carry out in an
probability to analyze the risks associated economically depressed period – AIG came to
with the range of perils covered and the rate grief in 2007
and costs of future claims. Scientific http://en.wikipedia.org/wiki/American_International
principles are used to determine an insurer's _Group

overall exposure. Bear markets do cause insurers to shift away

from investments and to toughen up their
The accounting profession has had major underwriting standards. So a poor economy
difficulties in expressing the liabilities generally means high insurance premiums. This
associated with many, but not all insurance tendency to swing between profitable and
risks. Instructive are the cases of asbestos unprofitable time periods alternating over time
http://en.wikipedia.org/wiki/Asbestos and
cycles is commonly known as the "underwriting"
Equitable Life (in the UK) or "insurance" cycle.
http://en.wikipedia.org/wiki/The_Equitable_Life_As
surance_Society Property and casualty insurers currently make
the most money from their auto insurance line
Upon termination of a given policy, the amount of business. Generally better statistics are
of premium collected and the investment gains available on auto losses and underwriting on
thereon minus the amount paid out in claims is this line of business has benefited greatly
the insurer's underwriting profit on that from advances in computing. Additionally,
policy. For Lloyds of London, this works on a property losses in the US, due to natural
three-year basis – see http://www.lloyds.com/ catastrophes, have exacerbated this trend.
and http://en.wikipedia.org/wiki/Lloyd's_of_London
Finally, claims and loss handling is the
Of course, from the insurer's perspective, materialized utility of insurance. In managing
some policies are winners (i.e., the insurer pays the claims-handling function, insurers seek to

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balance the elements of customer satisfaction,
administrative handling expenses, and claims While insurance is analogous to gambling in
overpayment leakages. As part of this terms of risk and reward, the main difference
balancing act, insurance fraud is a major is in the motivation behind the process:
business risk that must be managed and - gamblers are risk seekers;
overcome. - insurance buyers are risk avoiders.

Gambling analogy Conclusion

Some people consider insurance a type of Risk management, the practice of appraising
wager (particularly as associated with moral and controlling risk, has evolved as a discrete
hazard) that is played out over the policy field of study and practice – see e.g.
period. The insurance company bets that an http://en.wikipedia.org/wiki/Risk_management
insured or its property will not suffer a loss
while the insured puts money on the opposite Avoiding, mitigating and transferring certain
outcome. The difference in the fees paid to risk creates greater predictability for
the insurance company and the amount for consumers and business, and allows people and
which it can be held liable if an accident organizations to act with freedom and a
happens is roughly analogous to the odds one release from worry. Clearly the idea for
might expect when betting on a racehorse (for everyone is to use risk management approaches
example, 10 to 1). For this reason, a number of intelligently to optimise your position.
religious groups, including the Amish and some
Muslim groups, avoid insurance and instead
depend on support provided by their
communities when disasters strike. This can
be thought of as "social insurance," as the risk
of any given person is assumed collectively by
the community who will all bear the cost of
rebuilding. In closed, supportive communities
where others can be trusted to step in to
rebuild lost property, this arrangement can
work.

However, this system will not work for large

risks. For very large risks, Western insurance
can also run into difficulties, the reason why
most U.S. homeowner's insurance does not
cover floods. Such companies can accurately
estimate the number of claims it would have to
pay because of fires, tornadoes, and other
smaller-scale disasters. However, a flood may
impact a large percentage of a city and the
company might be unable to pay such a large
number of claims and become insolvent. For
the same reason, losses due to war and
earthquakes are generally excluded. In the
case of floods and earthquakes (which occur on
a smaller scale than war does), homeowners
can purchase separate insurance from national
companies with larger resources and a greater
ability to distribute the risk across regions
rather than individual buildings.

In gaming or gambling, the game is fixed at the

start so that the odds are not affected by the
players. However, to obtain certain types of
insurance, such as fire insurance, policyholders
are often required to conduct risk mitigation
practices, such as installing sprinklers and
using fireproof building materials to reduce
the odds of loss to fire. In addition, after a
proven loss, insurers specialize in providing
rehabilitation to minimize the total loss.