Understanding how insurance works

Insurance is a mechanism for transferring and reducing pure risk through which a large number of individuals share in the financial losses suffered by members of the group as a whole. Insurance protects each individual in the group by replacing an uncertain and possibly large financial loss with a certain but comparatively smallfee. This fee, called the premium, has four components:
• The individual’s share of the group’s losses
• Insurance company reserves set aside to pay future losses
• A proportional share of the expenses of administering the insurance plan
• An allowance for profit (when the plan is administered by a profit-seeking company)

Insurance premiums are assessed on an annual or semiannual basis. You generally will be charged an extra amount if you choose to make the payments monthly. The insurance policy is the contract between the person buying insurance (the insured) and the insurance company (the insurer). It contains language that describes the rights and responsibilities of both parties. Most people do not take the time to read and understand their insurance policies. As a result, insurance remains one of the least understood purchases people make. You can do a much  better job of managing your risks if you understand the basic terms and concepts used in the field of insurance.

Hazards Make Losses More Likely to Occur
A hazard is any condition that increases the probability that a peril will occur. Driving under the influence of alcohol represents an especially dangerous hazard. Three types of hazards exist:

•  A physical hazard is a particular characteristic of the insured person or property that increases the chance of loss. An example of a physical hazard is high blood pressure in a person covered by health insurance.
• A morale hazard exists when a person is indifferent to a peril. For example, a morale hazard exists if the insured party, knowing that theft insurance will pay for the loss, becomes careless about locking doors and windows.
• A moral hazard exists when an insured person wants a peril to occur so that he or she can collect on an insurance policy. Insurance companies often limit or deny coverage if a loss occurs as a result of a morale or moral hazard.

Only Certain Losses Are Insurable
Certain minimum requirements must be met for a loss to be considered insurable in particular, the loss must be fortuitous, financial, and personal. Fortuitous losses are unexpected in terms of both their timing and their magnitude. A loss caused by a lightning strike and fire to your home is fortuitous; a loss caused by a decline in the market value of your home is not because it is reasonable to expect home values to rise and fall over time. A financial loss is any decline in the value of income or assets in the present or future. Financial losses can be measured objectively in dollars and cents. When you become sick, you suffer as a result of the discomfort, inconvenience, lost wages, and medical bills. Insurance will cover only the lost wages and medical bills, however, because these losses but not the others can be objectively measured. Finally, personal losses can be directly suffered by specific individuals or organizations rather than society as whole.

The Principle of Indemnity Limits Insurance Payouts
The principle of indemnity states that insurance will pay no more than the actual financial loss suffered. For example, an automobile insurance policy will pay only the actual cash value of a stolen automobile. This principle prevents a person from gaining financially from a loss. Furthermore, it does not guarantee that insured losses will be totally reimbursed. Every policy includes policy limits, which  specify the maximum dollar amounts that will be paid under the policy. These limits explain why there is no such thing as “full coverage” insurance there is always the potential that a loss will exceed the limits on a policy. As a result, insurance purchasers must carefully select policy limits sufficient to cover their potential losses.

Factors That Reduce the Cost of Insurance
Some specific features of insurance policies can lower your premiums without significantly reducing the protection offered. These features include deductibles, coinsurance, hazard reduction, and loss reduction. Deductibles are requirements that you pay an initial portion of any loss. For example, automobile collision insurance often includes a $200 deductible. With such a policy, the first $200 of loss to the car must be paid by the insured. The insurer then pays the remainder of the loss, up to the limits of the policy. You usually have a choice of deductible amounts.

Coinsurance is a method by which the insured and the insurer share proportionately in the payment for a loss. For example, health insurance policies commonly require that the insured pay 20 percent of a loss and the insurer pay the remaining 80 percent. Substantial premium reductions can be realized through coinsurance, but you must be prepared to pay your share of losses. The following deductible and coinsurance reimbursement formula can be used to determine the amount of a loss that will be reimbursed when the policy includes a deductible and a coinsurance clause:

As an example, assume you have a health insurance policy with a $100 deductible per hospital stay and a 20 percent coinsurance requirement. If the hospital bill is $1350, the reimbursement will be $1000, calculated as follows.

Hazard reduction is action taken by the insured to reduce the probability of a loss occurring. Insurance companies often offer reduced premiums to insureds who practice hazard reduction for example, to nonsmokers. Loss reduction is action taken by the insured to lessen the severity of loss if a peril occurs. Smoke alarms and fire extinguishers in the home are examples of loss reduction efforts. These items will not prevent fires, but their use may lead to less severe damage. Many property insurers offer reduced premiums to insureds who practice loss reduction.

The Essence of Insurance
Insurance consists of two basic elements: the reduction of risk and the sharing of losses. When you buy insurance, you exchange the uncertainty of a potentially large financial loss for the certainty of a fixed insurance premium, thereby reducing your risk. Risk is reduced for the insurer as well through the law of large numbers: As the number of members in a group increases, predictions about the group’s behavior become increasingly more accurate. This greater accuracy decreases uncertainty and, therefore, risk.

To illustrate, consider a city of 100,000 households in which the probability of a fire striking a household is 1 in 1000, or 0.1 percent. Thus, 100 home fires are likely to occur each year in this community. If we focus on groups of 100 households at a time, we cannot predict very accurately whether a fire will strike a house in a given group. Some groups might have two or three fires, while others might experience none. If we combine all the households into one group, however, we can more accurately predict that 100 fires will occur (100,000 0.001). Even if 103 fires occurred, our prediction would be in error by only a small percentage. Insurance companies, which may have millions of customers, can be even more accurate in their group predictions. Individual insurance purchasers benefit regardless of whether they actually suffer a loss because of the reduction of risk. This is the essence of insurance.  Reduced risk gives one the freedom to drive a car, own a home, and plan financially for the future with the knowledge that some unforeseen event will not result in financial disaster.

Who Sells Insurance
Sellers of insurance, called insurance agents, represent one or more insurance companies. They have the power to enter into, change, and cancel insurance policies on behalf of these companies. Two types of insurance agents exist: independent agents and exclusive agents. Independent insurance agents are independent businesspeople who act as third-party links between insurers and insureds. Such agents earn commissions from the companies they represent and will place each insurance customer with the company that  they believe best meets that customer’s particular needs

Exclusive insurance agents represent only one insurance company for a specific type of insurance. They are employees of the insurance company they represent. Life insurance, for example, is often sold through exclusive insurance agents. Not all companies use agents to market their policies. Companies referred to as direct sellers market their policies through salaried employees, mail-order promotions, newspapers, the Internet, and even vending machines. Any type of insurance can be sold directly. For risk managers who know what coverage they need, the lowest insurance premiums can be found with direct sellers.

Each type of seller presents both advantages and disadvantages. Independent agents may provide more personalized service and can select among several companies to meet a customer’s needs. Exclusive agents can provide personalized service as well but are limited to the policies offered by the one company they represent; their sales commissions tend to be low.

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