Insurance.docx

Insurance ========= Brief definition of Insurance ----------------------------- There is no single definition of insurance. Insurance can be defined from the viewpoint of several disciplines, including law, economics, history, actuarial science, risk theory, and sociology. Insurance is the pooling...

Insurance ========= Brief definition of Insurance ----------------------------- There is no single definition of insurance. Insurance can be defined from the viewpoint of several disciplines, including law, economics, history, actuarial science, risk theory, and sociology. Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk. Law of Large Numbers in Insurance ================================= The law of large numbers (or the related central limit theorem) is used in the literature on risk management and insurance to explain pooling of losses as an insurance mechanism. Also called the "law of averages", the principle holds that the average of a large number of independent identically distributed random variables tends to fall close to the expected value. This result can be used to show that the entry of additional risks to an insured pool tends to reduce the variation of the average loss per policyholder around the expected value. When each policyholder's contribution to the pool's resources exceeds the expected loss payment, the entry of additional policyholders reduces the probability that the pool's resources will be insufficient to pay all claims. Thus, an increase in the number of policyholders strengthens the insurance by reducing the probability that the pool will fail. In the insurance industry, the law of large numbers produces its axiom. As the number of exposure units (policyholders) increases, the probability that the actual loss per exposure unit will equal the expected loss per exposure unit is higher. To put it in economic language, there are returns to scale in insurance production. In practical terms, this means that it is easier to establish the correct premium and thereby reduce risk exposure for the insurer as more policies are issued within a given insurance class. An insurance company is better off issuing 500 rather than 150 fire insurance policies, assuming a stable and independent probability distribution for loss exposure. To see it another way, suppose that a health insurance company discovers that five out of 150 people will suffer a serious and expensive injury during a given year. If the company insures only 10 or 25 people, it faces far greater risks than if it can ensure all 150 people. The company can be more confident that 150 policyholders will collectively pay sufficient premiums to cover the claims from five customers who suffer serious injuries. Basic Characteristics of Insurance ================================== Pooling of Losses ----------------- Pooling is the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss. Pooling involves the grouping of a large number of exposure units so that the law of large numbers can operate to provide a substantially accurate prediction of future losses. Ideally, there should be a large number of similar, but not necessarily identical, exposure units that are subject to the same perils. Thus, pooling implies (1) the sharing of losses by the entire group and (2) prediction of future losses with some accuracy based on the law of large numbers. The primary purpose of pooling, or the sharing of losses, is to reduce the variation in possible outcomes as measured by the standard deviation or some other measure of dispersion, which reduces risk. Payment of Fortuitous Losses ---------------------------- A fortuitous loss is one that is unforeseen and unexpected by the insured and occurs as a result of chance. In other words, the loss must be accidental. The law of large numbers is based on the assumption that losses are accidental and occur randomly. For example, a person may slip on an icy sidewalk and break a leg. The loss would be fortuitous. Risk Transfer ------------- Risk transfer means that a pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position to pay the loss than the insured. From the viewpoint of the individual, pure risks that are typically transferred to insurers include the risk of premature death, excessive longevity, poor health, disability, destruction and theft of property, and personal liability lawsuits. Indemnification --------------- Indemnification means that the insured is restored to his or her approximate financial position prior to the occurrence of the loss. Thus, if your home burns in a fire, a homeowner's policy will indemnify you or restore you to your previous position. If you are sued because of the negligent operation of an automobile, your auto liability insurance policy will pay those sums that you are legally obligated to pay. Similarly, if you become seriously disabled, a disability-income insurance policy will restore at least part of the lost wages. Fundamental Principles Governing General Insurance Contracts ============================================================ The business of insurance aims to protect the economic value of assets or life of a person. Through contract of insurance, the insurer agrees to make good any loss on the insured property or loss of life (as the case may be) that may occur in course of time in consideration for a small premium to be paid by the insured. These principles provide guidelines based upon which insurance agreements are undertaken. Also, a proper understanding of these principles is necessary for a clear interpretation of insurance contracts and helps in proper termination of contracts, settlement of claims, enforcement of rules and smooth award of verdicts in case of disputes. Principle of Insurable Interest ------------------------------- It is generally defined as the legal right to insure arising out of a financial relationship recognized under the law, between the insured and the subject matter of insurance. It is simply the "right to insure". It states that the insured must be in a position to lose financially if a covered loss occurs. The policyholder must have a pecuniary or monetary interest in the property, which he has insured. As a general rule, if the insured has no insurable interest over the life or a property he insures, the insurance contract is considered unenforceable. For a simple example, if you own a car, therefore you have an insurable interest to it because you may lose financially when it gets damaged or stolen. Likewise, you have insurable interest in your personal properties such as your clothes, books, laptops, cellphones, etc. because you may lose financially if these properties of yours are damaged, stolen or destroyed. Principle of Utmost Good Faith ------------------------------ It is very important that upon undertaking an insurance, there must be a positive duty to voluntarily disclose, accurately and fully, all facts material to the risk being proposed, whether requested or not. This principle of insurance stems from the doctrine of *["Uberrimae Fides"]* which is essential for a valid insurance contract. It implies that in a contract of insurance, the concerned contracting parties must rely on each other's honesty. Remember that in Insurance, the products sold are intangible. Here the required facts relate to the proposer, those that are very personal and known only to him. The law imposes a greater duty on the parties to an insurance contract than those involved in commercial contracts. They need to have utmost good faith in each other, which implies full and correct disclosure of all material facts by both the parties to the contract of insurance. Thus, any concealment of necessary facts is deemed intentional and will make the policy to be considered as void. Utmost good faith principle imposes duty of disclosure on both the insurance agent and the company authorities also. Any laxity at this point may tilt judgments-in favor of the insured in case of a dispute. However, some the following facts need not be disclosed: - Circumstances which diminish the risk (such as fire or burglar alarms set) - Facts which are known or reasonably should be known to the insurer in his ordinary course of business - Facts which are waived by the insurer - Facts of public knowledge - Facts of law - Facts covered by policy conditions Other things to remember: - [Representations] are statements made by the applicant for insurance. For example, upon applying for a life insurance, you may be asked questions concerning your age, weight, height, occupation, state of health, family history, and other relevant questions. Your answers to these questions are called representations. - The insurance contract is voidable at the insurer's option if the representation is ***material, false and relied*** on by the insurer. - [Material] means that if the insurer knew the true facts, the policy would not have been issued, or it would have been issued on different terms. - [False] means that the statement is not true or is misleading. - [Reliance] means that the insurer relies on the misrepresentation in issuing the policy at a specified premium. Principle of Indemnity ---------------------- 'Indemnity' is 'the protection or security against damage or loss or security against legal responsibility'. Indemnity may be referred to as a mechanism by which insurers provide financial compensation in an attempt to place the insured in the same pecuniary position after the loss as enjoyed just before it. The literal meaning of the term "Indemnity" is making good the loss. On the happening of the insured event for which the insurance policy is taken up the insured should be replenished the amount of loss. Here, the insurance companies undertake to compensate the insured upon fulfillment of all the stipulations that are agreed upon in the insurance contract. The insurer charges a small amount as premium for undertaking the liability to cover the risk and in return promises to pay the value of the insurance policy or the amount of loss whichever is lower. The principle of Indemnity ensures that the insurer is liable to pay up to the amount of loss and not more than that. In other words, it implies that the insured should not derive any unwarranted benefit from a loss. Thus, the insurer seeks to restore the same financial position of the insured prior to occurrence of the loss. The principle of indemnity has two fundamental purposes: - *To prevent the insured from profiting from a loss*. Example, Angelo's house is insured for 500,000 Pesos and a partial loss occurred amounting to P200,000. The principle of indemnity will be violated if the full P500,000 would be paid to him because he would be profiting from the insurance. - *To reduce moral hazard*. If a dishonest policyholder could profit from the insurance, they might deliberately cause the loss with the intention of collecting the proceeds from the policy. *[Exception to the principle of indemnity -- life insurance:]* The life of a person is different from a material or property. The principle of valuing material property like replacement cost less depreciation and discounted cash flows cannot be applied to determine the monetary value of the life of a person. The value of life is broadly determined by certain qualitative factors and is subject to one's opinion. The most important factor here is the earning capacity of the person and the insurable value is the value of the policy taken up by the person. A life insurance policy is not subject to the principle of indemnity but is a valued policy wherein the agreed upon amount in full is paid to the beneficiary in case of loss of life. Principle of Contribution ------------------------- Contribution is the right of an insurer to call upon others similarly, but not necessarily equally liable to the same insured to share the cost of an indemnity payment. This principle of contribution enables the total claim to be shared in a fair way. As per the doctrine of contribution the indemnity provided for the loss occurring on the asset, which is insured with several insurers has to be proportionately shared among them according to the ratable proportion of the loss. That is, the amount of total compensation or indemnity provided to the insured by all the insurers should not exceed the amount of loss. Sometimes when the value of the asset is very high the amount of risk involved is higher and that particular asset if insured by the company forms a significant portion of the total risk. This in turn increases the business (operation) risk of the insurance company. Usually, insurance companies try to concentrate on a higher number of policies of lower value for diversification benefits. Diversification serves to reduce the overall risk level of an insurance company. Rather than avoiding business arising from high value assets insurers follow the practice of underwriting high value assets partially. Thus, a single insurer takes up a part of the total value of the asset and the asset is insured by a group of two or more insurance companies. This practice has further implications particularly in case of settlement of claims relating to such contracts. The question of how much of the compensation is to be borne by each Insurer has to be addressed. It is here that the doctrine of Contribution is applied to resolve such complications. Here, the insured has the choice to recover from any insurer on a priority basis. After recovering the share of loss from the first insurer the insured can approach other insurers as per the doctrine of contribution. Requisites to invoke the doctrine of contribution: 1. The insured asset/Person (in case of hospitalization insurance) must be common to all the policies 2. The risk insured against must be common to all the policies 3. The insured owner of the asset must be the same person 4. All the policies must be in force during the occurrence of loss Principle of Proximate Cause ---------------------------- It is not the latest, but the direct, dominant, operative and efficient cause that must be regarded as proximate. The term "Proximate cause" literally means the nearest cause or direct cause. In insurance parlance it relates to the immediate cause of the mishap, which resulted in the loss If a person has bought fire insurance for his house the protection will be from the loss caused by fire, which may have resulted from the sources mentioned in the policy. In case the fire occurs from any source other than that mentioned in the policy the insurer is not liable to compensate the insured. For example, if the person is insured to be protected against fire occurring due to electric short circuit and the fire occurs due to leakage of LPG cylinder then the insurance company is not liable to pay for the losses. In this case only if the fire were caused by short circuit would the loss be covered. All the details related to proximate cause have to be clearly mentioned at the time of entering into the contract. Sometimes the causes not covered by the policy have to be expressly mentioned and though it is impossible to mention the whole range of causes that are to be avoided they are usually assumed by implication. The replenishment of compensation proceeds strictly depends upon the causes agreed upon. It has to be noted that while determining 'proximate cause' the sequence of events according to their time of occurrence is irrelevant. The deciding factor is the correct cause of loss. Principle of Subrogation ------------------------ Subrogation means the restitution of the rights of an assured in favor of the insurer against the third party for any damages caused by him in place of the assured after the insurer has indemnified him for the loss. *The principle of subrogation is invoked when a third party is responsible for the loss*. It is to be noted that on the happening of the event for which the asset has been insured and after the damage has been caused the insured can sue the party who has caused the damage to claim compensation for the loss. Alternatively, the insured can seek compensation from the insurance company. In case the insured opts for the latter course he loses the right to sue the party, who has caused the damage and seek further compensation from him. In accordance with the principle of subrogation the insurance company acquires the right of the insured to sue the third party to compensate for his negligence and loss inflicted upon when it indemnifies the insured for the losses suffered by him. *Purposes of Subrogation* First, subrogation prevents the insured from collecting twice for the same loss. In the absence of subrogation, the insured could collect from his or her insurer and from the person who caused the loss. The principle of indemnity would be violated because the insured would be profiting from a loss. Second, subrogation is used to hold the negligent person responsible for the loss. By exercising its subrogation rights, the insurer can collect from the negligent person who caused the loss. Lastly, subrogation helps to hold down insurance rates. Subrogation recoveries are reflected in the ratemaking process, which tends to hold rates below where they would be in the absence of subrogation. Although insurers pay for covered losses, subrogation recoveries reduce the loss payments. ### Limitations of Subrogation 1. The general rule is that by exercising its subrogation rights, the [insurer is entitled only to the] [amount it has paid under the policy]. Some insureds may not be fully indemnified after a loss because of insufficient insurance, satisfaction of a deductible, or legal expenses in trying to recover from a negligent third party. Many policies, however, now have a provision that states how a subrogation recovery is to be shared between the insured and insurer. 2. After a loss, the [insured cannot impair or interfere with the insurer's subrogation rights]. The insured cannot do anything after a loss that interferes with the insurer's right to proceed against a negligent third party. For example, if the insured waives the right to sue the negligent party, the right to collect from the insurer for the loss is also waived. This could happen if the insured admits fault in an auto accident or attempts to settle a collision loss with the negligent driver without the insurer's consent. If the insurer's right to subrogate against the negligent motorist is adversely affected, the insured's right to collect from the insurer is forfeited. 3. Subrogation [does not apply to life insurance contracts]. Life insurance is not a contract of indemnity, and subrogation has relevance only for contracts of indemnity. 4. The [insurer cannot subrogate against its own insureds]. If the insurer could recover a loss payment for a covered loss from an insured, the basic purpose of purchasing the insurance would be defeated.