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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