Institutional Constraints to Insurance

Some important institutional constraints on the existence or availability of insurance contracts come from law, custom, and the organization of the insurance market.  They usually differ in different countries according to the political or economical environment.

Regulatory Constraints

Regulations affect the availability of insurance with regards to the type of coverage that can be written and the type of institution that can write insurance contracts. For example, in most countries, insurance companies are forced by law to specialize in property and liability insurance or in life insurance.  In the early years of insurance, each line of business had to be approved separately.  From this point of view, the American regulatory tradition has been more restrictive than the British regulatory tradition. The traditions persist, even when traditionally separate lines of insurance are provided by a single company, the traditional divisions and wording of coverage exist.

Risks Insurable by Governments Only

Where the government is itself in the insurance business, it uses political means to protect its market position or to prohibit the writing of insurance contracts for certain types of coverage.  For example, health insurance is part of the Social Security system of many European countries and is operated by the State.

Market Organization

Almost all countries require by law that insurance on local insurable interest bepurchased in locally licensed companies.  There is of course a conflicting situation when the economic agent is located at a different place than the insurable interest (this is typically the case in marine insurance).

Some laws and regulations specifically prohibit the licensing of insurers or insurance operations of particular types. Whether these particular regulations have the effect of producing a shortage of insurance depends on a variety of factors.  Market imperfections may also exist concerning the availability of some types of coverages because of the limited size of the market, the small size of the companies, or the lack of expertise and know-how.

Summary

In this chapter the following issues are addressed: (1) the benefits and costs generated by the existence of insurance contracts, (2) the characteristics of insurable risks and, (3) the legal characteristics of insurance contracts. These issues are essentially conceptual in nature and provide an important background affecting the practice ofinsurance.

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Legal Aspects of an Insurance Contract

Standardization and Structure of Contracts

The terms of an insurance contractare embodied in a written document called the insurance policy. Policy forms vary in complexity depending upon the type of insurance coveragebut a certain degree of standardization exists and these standards are very similar from one country to another. Also, a certain degree of uniformity exists and is essential in the presentation  (the structure) of insurance policies

The terminology used is peculiar to insurance but the declarations, insuring agreement, definitions, exclusions, and conditions are the essential parts of all insurance policies.  In addition to the basic policy form, an insurance policy frequently contains several attached forms, riders, or endorsements modifying the coverage.

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The Characteristics of Insurance Contracts

Insurance contracts, in all countries, are subject not only to the same basic law that governs all types of contracts, but also to some legal principles that have been developed to handle the legal problems associated with insurance and summarized

In order for a contract to be legally valid there must be (1) an agreement between the two parties (usually refer to "offer and acceptance"), (2) a valuable consideration, and  (3) legal capacity and purpose.  Beyond the necessary contractual conditions, certain elements are peculiar to the insurance policy. Generally the policy is unilateraland only the insurer is obligated to act. It is also a conditional and aleatory contract.

As a contract of "utmost good faith," (uberrimae fidei) a certain degree of honesty is presumed from both parties.  This principle imposes a higher standard of honesty on the two parties than is usually expected in ordinary commercial contracts. To avoid a contract, a warranty (a statement contained in the contract and which requires that a particular condition exists) must be false, a representation (a statement made by the insured to the insurer on which the latter relies to price the contract) must be false and materially important, and concealment made with intent to deceive (the insured has an obligation to inform the insurer about facts that may be materially important).

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The Concept of Insurable Interest

Ina broad legal sense, an insurable interest is the kind of financial interest a person must possess in order to have legally enforceable insurance coverage. Section 5(2) of the Marine Insurance Act 1906 in the United Kingdom defines the insurable interest as: "In particular a person is interested in a marine adventure where he stands in any legal or equitable relation to the adventure or to any insurable property at risk therein, in consequence of which he may benefit by the safety or due arrival of insurable property, or may be prejudiced by its loss, or by the damage thereto, or by the detention thereof, or may incur liability in respect thereof."

In property insurance, a person has an insurable interest in a property whenever he may sustain direct and immediate damage by its loss or deterioration.  Future property and incorporeal property may be the subject of a contract of insurance.  The insurable interest need not exist at the time the insurance is purchased but must exist at the time of the loss. The insurance of a property in which the insured has no insurable interest is without effect.  The approach is similar for liability coverages.

Property and liability insurancecontracts are contracts of indemnity.  Therefore the monetary value and definition of the coverage must be stipulated in the contract.  It is also explicitly mentioned that duplicate coverage for the same insurable interest is not possible. This is evident for a property coverage to avoid multiple indemnification;  the provision is different for liability coverages if different limits of coverage are specified in several contracts. 

In addition to preventing the insured from collecting several times for the same loss, the insurance company has a subrogationright.  After the insured has been indemnified, the insurance company is subrogated to the insured's rights of recovery from anyone causing the loss.   However, the right of subrogation is not automatically accorded to insurers under every type of coverage they write. For example, in the common law, subrogation is automatically allowed for property insurance coverages but always denied to life insurers.

If there is a recognized insurable interest, arisk can be insured even if no statistics or risk analysis is possible.  This is brought out by the following case reported by Brown (1973):

In 1971, the whisky distillery Cutty Sark offered an award of one million pounds for the capture of the monster assumed to live in the Loch Ness in Scotland. Cutty Sark approached Lloyd's of London about the possibilities of insuring against the eventual discovery and the financial consequence for the firm. The premium was fixed at £ 2,500 to cover the risk of the monster being captured alive between May 1, 1971 and April 30, 1972. The definition of a "monster" was the following; "As far as this insurance is concerned the Loch Ness Monster shall be deemed to be: (1) in excess of 20 feet in length, (2) acceptable as the Loch Ness Monster to the curators of the Natural History Museum, London."

In life insurance, the contract is without effect if at the time of contacting it, the policyholderhas no insurable interest in thelife or health of the insured.  A person has an insurable interest in his own life and health and in the life and health: (a) of his consort, (b) of his descendants and of those of his consort, whatever their filiation, (c) of any person upon whom he is dependent for support or education, (d) of any person in whose life and health the insured has a pecuniary interest.

The creditor has an insurable interest in the life of the debtor that is equal to the amount of the debt and interest. Business relationships, other than that of a creditor and a debtor, can justify that an employer has an insurable interest on a key employee, a partner, a board officer. In all cases, however, the person being insured must agree to the proposed contract.

The absence of an insurable interest does not prevent the formation of the contract if the insured gives his written consent.  Contrary to property and liability insurance contacts, life insurance contracts make no reference to indemnification

because the value of a human life is not defined.  Therefore there is no problem of duplicate insurance.  In fact there is no problem if an individual wants to buy several life insurance contracts with one or more insurance companies. For the same reason,  life insurers do not posses subrogation rights.

In Health insurance, all types of medical expense coverages are contracts of indemnity and are similar to property and liability contracts.  On the other hand, income replacement paid under health insurance contracts must be assimilated to a life insurance type of coverage.

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Insurance and Loss Control

Because of the existence of indirect costs,like moral and morale hazards, generated by insurance contracts, insurers have created loss controldevices or activities to offset these costs.

Pre-loss Control

Insurance is clearly limited only to pure risks although there are some examples of risks of a speculative nature that have been proposed in the recent past . Insurance contracts also contains limits that state the types of perils to be covered and the maximum amount of loss exposure.  The underwritingprocess (the underwriter) determines the eligibility of the insurance buyer, the types of risks to be covered, the amount at risk for insurance coverage and other informations affecting the insurability of the risks. Most insurance contracts cover losses up to a stated maximum monetary amount that may differ depending upon the perils, persons, types of loss, or locations covered. Limits may be stated as a maximum amount that is payable per occurrence, regardless of the number of occurrence, or as an aggregate limit which state the maximum amount the insurer will pay because of occurrences during the period of coverage (usually one year).  However in a liability coverage many contracts do not impose a limit on the maximum possible loss.  In some countries, limits on some types of liability coverage are even illegal (automobile insurance is the most common case). 

A deductibleis an example of insurance device that requires an insured to bear part of the potential loses covered under the contract (provisions for loss-sharing).  Typically the insurer will pay only the losses exceeding a predetermined amount of money. For an individual fire insurance contract or automobile insurance contract, this amount will probably be less than 1 percent of the amount of coverage although the insured may have the choice of several deductible amounts.  

For a contract covering the needs of a firm, the deductible may be much higher because the firm is willing (has the capacity) to retain a higher portion of the loss exposure. However, deductibles are often imposed by the insurer rather than selected by the insured.

Monetary deductibles are of two types. A per-occurence deductible applies to each loss.  An aggregate deductible applies only up to a cumulated amount during the period of the contract (one year).  Quite often the two deductibles are used together.

The deductible may require the insured to pay a fixed percentage of every loss that occurs, up to a given maximum annual amount defined in the contract (this is typically the case of health insurance contracts). The term "coinsurance" is often used (misused) to describe loss-sharing arrangements, especially in health insurance. The percentage of coverage, for example the contract will reimburse 80% of incurred losses, is usually in excess of any aggregate deductible. 

In health insurance, the term "co-payment" is also used to define a fixed monetary deductible applying to each occurence in addition to the annual deductible. For example a $10 co-payment for a visit to a doctor instead of a reimbursement rate of 90%.

Besides the usual deductibles, the concept of disappearing deductibleis often used for large business risks.  Under a disappearing deductible, the size of the deductible decreases as the size of the loss increases.  At a given level of loss 

(L*) the deductible is equal to zero (disappears).  The formula to apply the reduction in the deductible (D)  is the following:

Compensation by the insurer = ( Amount of loss  -Deductible) x (1+k)where k is the adjusting factor:

If the adjusting factor is fixed at 5% and the deductible is $1,000, then the deductible will disappears when the loss equals or exceeds $21,000.  All losses under $1,000 are absorbed by the insured.  On a loss of $15,000 the insurer would pay $14,700 ( a $300 deductible).

Afranchise, often used in marine insurancecontracts and engineering, is a limit expressed as a percentage of value or as a monetary amount under which no compensation is paid by the insurer.  The difference with a deductible is that when the loss equals or exceeds the limit (amount), the insurer must pay the entire loss without any deductible. The purpose of a franchise is to avoid smaller losses to reduce administrative expenses. 

In some cases, like health insurancecontracts or unemployment insurance contracts, the deductible is not only a monetary deductible but also a time deductible called a waiting periodor an elimination period.  Coverage for the peril, accident, injury or illness will start only after a predetermined period of time defined in days or months. It is a limitation on benefits used to limit moral hazard or eliminate duplication of coverage.  From this point of view, the suicide clause Similar to monetary deductibles, the longer the waiting period, the lower the premium, other things being equal.

Regardless of the form of the deductible, the obvious effect is also to make the insured more careful because he will have to pay his share of the loss. The secondary effect is that the administrative expenses faced by the insurance company to settle a claim will be reduced if there is a significant number of losses smaller than the deductible.  The advantage for the insured is that the premium will be lower than for full coverage. 

A coinsuranceclause is another device, or clause of a contract, which protect the insurer against wrong evaluation (or declaration) by the insured of the value of the property at risk. It is often used in property damage to houses or buildings because in most cases the damage is only partial and it creates an incentive for the insurance buyer to undervaluate the coverage.

If the insured fails to carry an amount of insurance coverage at least equal to some specified percentage of the value of the property at the time of the loss, the insurer will not pay the full amount claimed.  In all cases, the amount the insurer will pay is either the total loss up to the insurance coverage (eventually minus the deductible) or a lower amount determined by the following formula: 

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The Benefits of an Insurance Market

What explains the existence of organizations selling insurance contracts?  Many of the reasons in the Mayers and Smith paper mentioned in a previous chapter can apply again.

Insurance organizations might outperform the individual because there are transactions costs that exist in identifying andmatching the individuals that are willing to sell/buy insurance to/from each other. There are scale economies in

An insurer also have a comparative advantage in providing services to individuals and corporate entities. Pre-loss services include the loss prevention activities developed by the insurer such as on-site inspections. Post-loss services are related to the administration of claims and include adjustment services, legal defense services.

The reduction of uncertaintyis possible at the macroeconomic level (for the society as a whole) because there is a large number of insurance contracts and therefore a reduction of risk through pooling and diversification.

The payment to buy an insurance contract is made before the insured benefits from the potential indemnification.  This is often referred to as an "inverse cycle of production".  At the macroeconomic level, the premiums are collected by the insurer (or the market) during a budgetary year to cover immediately the claims incurred within that period or to cover for claims that will occur in an uncertain future. Although the purpose of insurance is not to save (at least in the usual meaning of that term, i.e. the transferof purchasing power from one period to another ), it is clear that insurance contracts generate funds that are available for investment.

Although insurance contracts generate transaction costs and also information costs,  at the macroeconomic level, the insurance industry contributes to the formation of national income. The service offered by the insurer is that of an intermediaryand the cost of insurance, which measures the effort made by the community to provide itself with an insurance system, generates the payment of salaries, commissions and  dividends.

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Benefits and Costs of Insurance

The Expected Benefits of Insurance Contracts

The direct advantage of an insurance contract is the exchange, for a fixed fee, of the uncertainty concerning a potential loss, for the certainty of indemnificationin the case the insured suffer a loss.  Indemnificationor compensation is the primary reason why an individual or a firm would buy an insurance contract.

The reduction of uncertaintyis the other motivation because individuals are risk averse. The certainty concerning the outcome of a risky situation is, in the case of a pre-loss financing arrangement, one of the risk management objective of the firm.

The Costs Generated ByInsurance Contracts 


Insurance contracts also generate direct and indirect costs that may have an impact on the offer of optimal contracts and the efficient allocation of the risks to the insurer.

Transaction costsare important and they reflect the costs of distributing and servicing the contracts to the insured. For property and liability insurancecontracts, in terms of premium income, these expenses account on average for about 30 to 35 percent (excluding taxes) but vary greatly in different countries according to the organization of the market, as well as among the different types of insurance coverages and insurance companies. The percentages in the life insurancebusiness are usually lower but vary also greatly according to the same kind of factors.

Moral Hazardis a condition that increases the expected frequency or severity of a loss. It is an intentional act inspired by the possibility of recovering an amount of money from an insurance contract in force.  Arson, for example, is a cause of fire. Increasing the amount of a loss by making a false claim (property insurance), by overutilizing the services (health insurance), by charging excessive costs to repair the damage (automobile insurance) or by granting excessive awards in a judgment (liability insurance), generate a higher cost than expected and must be taken into account  in the premium that is paid by all insured for any kind of coverage.

For K. Borch (1990, p. 325) there is no doubt that the concept of moral hazard has its origin in marine insurance.An insurance contract is based on good faith and fair dealing between the underwriter and the insured. The concept is subjective and the discrimination sometimes associated with particular countries or flags of convenience. It is easy to find other examples.  Moral hazard can clearly occur in any kind of insurance.  In a paper on moral hazard, Professor Stiglitz stressed the importance of incentives, and argued that insurance contracts should be designed so that they induce the insured to take good care ofhis property.4

Similarly, a morale hazardis a condition that causes an individual to be, consciously or unconsciously,  less careful because of the elimination of the uncertainty concerning the financial consequence of a risk. The probability and size of a loss is almost always influenced by an individual's actions. It is often recognized that insurance reduces the incentive for loss prevention and control.

The importance of moral hazard extends beyond the context of insurance to the entire paradigm of agency theory. It includes any inefficiency in the decision of a contractual party that results from externalities whenever one party is not assigned the full costs and benefits of a decision that affects other parties to the contract.5

Utmost good faith(Uberrima Fides), means that the parties to the contract would disclose to each other all the material facts about the risk and cover, fully, truly and faithfully. Any breach in the duty of disclosure whether by way of concealment, innocent misrepresentation or fraudulent misrepresentation, renders the contract voidable at the hands of the aggrieved party, usually the insurer.

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The Characteristics of an Ideally Insurable Risk

1.There should be a large number of independent, homogeneous loss exposures subject to the same peril.
2.The loss exposure should be definite in time, place, cause and amount.
3.The loss exposure should be calculable and the resulting premium should be economically feasible.
4.The loss should result from an accidental hazard not under the control of the insured.

To be insurable, the occurrence of a peril must be accidental.  It is only possible to insure against perils that are certain to occur if there is uncertaintyon the timing of the occurrence or the amount of the possible loss.2

An insurance contractis called an aleatory contract because there is an element of chance that is very much present in an insurance transaction.  Several centuries ago, some kinds of insurance contracts were held to be illegal because they were considered as gambling contracts. For example life insurance was not authorized in some countries because the Catholic Churchwas considering it as a gambling act on the life of the people.  Remember also that until the 16th century the Catholic Church prohibited usury.  The essence of gambling is the creation of risk.  Insurance does not create the risk  but only transfers an existing risk to an insurer.

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Insurable Risks

While the definition presented above indicates what insurance is from the point of view of the policyholder, there are many risks of economic loss that no insurance company is willing to accept.  From a risk management perspective the ideally insurable risk is a  pure, static and particular risk.  From the viewpoint of the insurer, certain conditions must exist before insurance is possible (Table 8.1).The fundamental requirement for the existence of insurance contracts is the existence of a large number of similar loss exposures.  What makes insurance feasible is the pooling of many loss exposures, homogeneous and independents, into classes (classes of business), according to the theory of probabilities (the law of large numbers).  Even if the probability that an event will occur is accurately known, the statistics do not apply to an individual exposure or even a  small group. Similarly, it may be difficult for an insurance company to cover catastrophic risks such as earthquakes, flood, or war damage, because it may affect a large number of insureds at once.

The pooling of loss exposures and the reduction of the risk of variation from the expected outcome is one reason insurance companies can issue insurance contracts to individuals unable to diversify themselves the risks. Another reason is that insurance companies can diversify the residual risk of each class of loss exposures by combining several classes of business into a portfolio.  An insurance
company cannot have all of its eggs in one basket.

The law of large numbers, though necessary for insurance, is not sufficient.  A further condition is the possibility to determine exactly the nature of the loss exposure and to be able to calculate, either by estimating the underlying probabilities, or by judgment, the frequencyand the severity of the possible loss. Moreover, even if the cost of insurance can be calculated, insurance is not practical if the premium that is determined by the insurer is too high and as a consequence the individual (or firm) is unwilling to pay for it. 

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Definition of an Insurance Contract

          A legal definition of insurance that  appears in many insurance laws is the following: A contract of insurance is that whereby one party, the insurer, undertakes, for a premium or an assessment, to make a payment to another party, the policyholder or a third party, if an event that is the object of a risk occurs.  It is often defined as a contract of indemnity. The insured is not to make any profit out of the insurance but should only be compensated to the extent of the pecuniary loss. 

          Although various definitions have been offered, one of the most helpful is to define insurance as a mechanism (or a service) for the transfer to someone called the insurer of certain risks of financial loss in exchange of the payment of an agreed fixed amount. The payment is due before the contingent claim is serviced by the insurer.

If from the insured's point of view, insurance is a "transfer," from the insurer's point of view, insurance as a "pooling" mechanism.  It is possible for the insurer to reduce the risk which he faces by offering an "insurance service," by pooling together alarge number of exposure units or risks.

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