In my previous post, I indicated that I was going through the process of obtaining the Associate of Insurance (AINS) certification. The first step is to complete the AINS 101 course, which covers the core basics of insurance. As the course has a lot to cover, I will be going through one section per blog post, starting with Why Do We Have Insurance?
1. Introduction to Insurance
What is insurance? Some people and businesses may be concerned about unforeseen events that may cause them to lose a lot of money. For instance, a big, scary tornado with an intense hatred of hats may target your newly-opened hat store, which would ruin your entire business! Insurance may not stop the tornado, but it may at least help you recoup your finances.
Insurance is a risk management system that transfers the risks of financial consequences resulting from loss exposures from an insured to an insurer. We’ll go over the concepts of risk, transfer, and pooling, which forms the basics of insurance. We will then go over the benefits of insurance for society as a whole.
Risk
Risk is uncertainty about outcomes, which can be positive or negative. For instance, if you purchase a home, you will be taking on negative risk, such as the possibility of the house catching on fire because you got a little too carried away torching those crème brûlée. However, you will also be taking on positive risk, such as the possibility of the price of the home raising because, damn it, houses just keep getting more expensive these days.
The purpose of insurance is to alleviate the uncertainty associated with negative financial consequences.
Transfer
The consequences of unanticipated events can be transferred to an insurer in exchange for a premium, which is simply the amount an insured routinely pays their insurer for their service. (I don’t know why they don’t just call it a subscription or something.) In the case of a huge negative financial consequence, the insurer will take on the burden at least partially.
Pooling
Pooling means that all of the insureds share the costs of each other’s losses. The premiums from customers are combined into a fund that is used to pay off losses. This system helps keep premiums affordable and helps the insurer cover large losses when they occur. Hooray, teamwork!
Benefits of Insurance
Insurance benefits society in several ways:
- Insurance indemnifies (restores to pre-loss status) individuals and organizations for covered losses.
- Manage cash flow uncertainty – financial effect on insured’s cash flow will be reduced to deductible payments or loss amounts that exceed the policy limits (as long as the loss is covered).
- Comply with legal requirements – some insurances are required by law, such as worker’s compensation and personal auto insurance.
- Promote risk control activity – some policies may require or provide incentives to insureds who undertake less risk, such as lowered premiums. Collected data can be used to prevent or limit losses.
2. Common Types of Insurance
There are two types of insurance – personal and commercial. The type you would need depends on what situations you are exposed to that could cause a loss, known as loss exposures.
Personal Insurance
Personal insurance serves as financial protection against losses that may arise in your daily personal life. They include the following:
- Property insurance – Covers the costs of repairing or replacing property that is damaged, lost, or destroyed. May also cover related lost income.
- Liability insurance – Covers the costs of injury to others or damage to others’ property for which the insured is legally responsible as well as costs related to defending the insured from related lawsuits.
- Life insurance – replaces the lost income-potential of the deceased. Also an inspiration for many hitmen stories.
- Health insurance – Everyone knows about this one (thanks, broken American healthcare system!) It protects from financial losses caused by sickness and bodily injuries. It is a legal requirement in the United States as of the time of writing.
There is another term that refers to both property and liability coverage – property-casualty insurance. It includes the following:
- Homeowners insurance – This is protection for when homes and/or belongings are damaged or stolen, as well as for liability coverage.
- Personal auto – This provides coverage for injuries or damages sustained by another party if the insured is at fault. It may also cover damages to the insured auto. This type of insurance is typically legally required.
- Personal umbrella – This is additional protection for people with high potential for large liability losses with policy limits usually in the millions. This is for people who have the ability to affect many people; for example, a family with two teenage drivers, two large dogs, and a pool has the potential to cause many accidents that can affect multiple people.
Commercial Insurance
Business operations are exposed to many risks; thus, businesses require commercial insurance. Businesses often purchase either a commercial package policy or a businessowners policy, both of which provide business owners with property, liability, and crime coverages. Here are some common types of commercial property-casualty insurance:
- Commercial property – Covers damage to buildings or their contents from fires, vandalism, and other causes of loss.
- Commercial crime – Protects against losses from theft of business property and money, including employee theft. My poor parents could have really used this.
- Commercial general liability – Protects a business against its legal liability to others for bodily injury and property damage, such as by issuing a $42,000 settlement for slipping on pee-pee at the Costco.
- Commercial auto – Covers liability for bodily injury and property damage caused by a business’s vehicle as well as damage to the business’s vehicle itself in an accident.
- Workers compensation – Legally required benefits that businesses are required to pay for their employees for job-related injuries and illnesses.
- Commercial umbrella – Provides additional liability limits beyond those provided by other commercial policies in the event of a large liability loss.
3. Types of Insurers
In the U.S., insurance is typically provided by private insurers; however, some loss exposures are covered by government programs.
Private Insurance
Private insurers are classified by two basic forms of ownership:
- Proprietary insurers – Earn a profit for their owners.
- Cooperative insurers – Provide insurance at a minimum cost to their owners, who are the policy holders.
Some common private insurers include:
- Stock insurer – Objective is to earn a profit. It attracts stockholders because of expectations of investment returns.
- Mutual insurer – Includes some large national insurers as well as regional ones. When more premiums are collected than it paid out for losses and expenses, it pays dividends to policy holders, sharing the profits.
- Surplus lines insurer – Provides insurance coverages unavailable in the standard market. Coverage for those in unique situations.
Reinsurance is a system that allows a primary insurer to transfer some loss exposures to another insurer, the reinsurer, which can help a small insurer provide insurance for large accounts.
Other Types of Private Insurance
- Reciprocal insurance exchanges – Each member is both an insurer and insured.
- Lloyd’s – Similar to a stock exchange – an insurance and reinsurance marketplace.
- Captive insurers – Formed to cover loss exposures of specific organizations.
Government Insurance
Government insurance exists to:
- Fill unmet insurance needs that private insurers refuse to or are unable to satisfy.
- Facilitate required insurance purchases, ensuring they are available at a reasonable price.
- Provide efficiency and convenience.
- Achieve social goals and reduce risks to society.
4. How Risk Management Has Evolved
Pure vs. Speculative Risk
- Pure risk – There is only loss and nothing gained from this kind of risk. For instance, a fire is a pure risk as you can experience losses from one, but do not gain anything when one does not occur. Pure risks are managed by purchasing insurance.
- Hazard risk – Arises from property, liability, or personal loss exposures.
- Operational risk – Arises from people, processes, systems, or controls.
- Speculative risk – This type of risk may cause gain or loss. One example is with the raising or decreasing market value of a home, which can be managed by maintaining the property to enhance resale value.
- Financial Risk – Arises from the effect of market forces on financial assets or liabilities.
- Strategic Risk – Arises from trends in the economy and society.
Evolving Technology
As risk management technology as become more accessible, business and people are investing more into preventing losses entirely instead of relying on insurance. Some of these technology include:
- Artificial Intelligence – Allows computers to perform tasks in place of a human, such as self-driving cars.
- Sensors – Allows monitoring of conditions on a continuous basis to warn of problems or malfunctions before they arise.
- Computer vision – Helps a machine recognize an object and respond to it as a human would. Used for automative checkout lanes, medical imaging, and automotive safety.
5. Conclusion
And this marks the end of today’s lesson on insurance and why we have it, as well as the many, many different types of insurances out there. The next post will cover the topic of How Do Insurers Succeed?