A financial definition of insurance
Throughout human history,unexpected economic losses have occurred.
Such losses would continue to occur whether or not a system of insurance had ever been devised.
But through the operation of an insurance system,losses can be predicted before they occur.
The predictability of losses in advance is basic to an insurance system's operations.
Because an insurance system allows losses to be predicted in advance,it allows the cost of losses to be financed and redistributed in advance.
The first definition of insurance that we will examine is the financial one.
In this instance,insurance is a financial arrangement that redistrbutes the costs of unexpected losses.
The insurance arrangement involves the transfer of many different exposures to loss to one insurance pool,
which combines the numerous exposures.
An insurance system accomplishes the redistribution of the costs of losses by collecting a premium payment from every participant in the system.
In exchange for the payment of the premium,the insured receives a promise from the insurance system to be compensated in the event of a loss.
In most insurance systems only a small percentage of those insured suffer losses.
Thus,an insurance system redistributes the costs of losses from the unfortunate few members who experience them,
to all the members of the insurance pool(including those who suffer losses) who have paid premiums.
Diagram 1 illustrates the way in which a fire insurance pool redistributes the costs of losses.
Assume that each member of the pool is exposed to loss of his home by fire.
Each member willingly contributed a premium-$800-to the insurance pool in exchange for the promise of payment in the event of fire.
Assume that homeowner #4644 loses his house in a fire.
He will collect $100,000, the insured value of his house,from the insurance pool.
If there were no insurance pool,the unfortunate victim would lose $100,000.
But instead,all the members of the pool have each paid $800 to provide funds to pay for losses.
Thus,each insured has paid a part of the $100,000 loss experienced by one member.
The $800 premium each insured paid in advance was calculated from the losses predicted by the insurance system.
When the year began it was not predicted that home #4644 would burn but,rather,that 33 houses from among the 5,000 insured would burn.
From this prediction came the decision to charge each homeowner $800 for his or her insurance.
An insurance system is able to operate because all the insureds are willing to substitute a relatively small certain outlay,
the insurance premium,for a relatively large uncertain loss.
It is generally assumed that most people find the possibility of suffering a large loss unpleasant to contemplate.
Therefore,people are willing to pay an insurance premium to be relieved of the uncertainty about a loss,
as well as to be compensated if the loss actually occurs.
Thus,even if no loss occurs during a year,as will be the case for most insureds,
value has still been received in the form of a reduced or eliminated unpleasant mental state,the anxiety about a loss.
Legal principles of insurance
HEADING A
It is sometimes said that insurance is like gambling.
In betting,for example,one gives a sum of money to a bookmaker who agrees to pay out on the bet if the horse one has backed wins the race.
The law however has found a means of distinguishing between gambling contracts,
which it will not enforce,and insurance contracts,which it will.
For a contract to be one of insurance the insured person must have an insurable interest in the subject matter of the insurance.
That is,he must stand to lose financially if the event insured against happens.
In life insurance,for example,a man or woman obviously has an interest in his or her own life and can therefore insure it and also the life of a husband or wife.
But one cannot insure the life of anybody else unless their death would result in financial loss to oneself.
Similarly,with property,insurance may only be effected if one stands to lose financially by its loss or destruction.
Clearly the owner of the property would lose but so also might other people,
such as a building society which has lent money on the security of a house or a dry cleaner who has taken in clothes for cleaning.
HEADING B
Further,in insurances on property or against liabilities the law applies the principle that the policyholder must not make a profit if the event insured against happens.
The insurance contract is said to be one of indemnity,to make good the insured's loss and no more.
Suppose,for example,that property is insured for more than its value and is destroyed as a result of an event insured against.
The insured's recovery will be limited to the actual value.
Again,if the property has been insured twice over and is destroyed,the insured will not be entitled to recover in all more than its total value.
And if insured property is destroyed in circumstances which give the insured a right to claim both against his own insurer
and against some other person who was responsible for the damage,the insured must allow the insurer to have the benefit of the right to claim against the other person.
HEADING C
Contracts of insurance form a special class of contract in that the law requires both parties to them,
the insured and the insurer,to exercise the utmost good faith towards each other.
In particular when anyone applies for insurance(he is known as the proposer) he must tell the prospective insurer every fact that he knows,
or ought to know which would influence a prudent insurer in deciding whether to grant the insurance and,if so,on what terms.
To take an example,a proposer for life insurance must reveal if he has recently had a heart attack as this may be a sign that he is more likely to die prematurely.
Similarly if a motorist is seeking to insure his car and has had a number of recent road accidents,
he must reveal that fact so that the insurer can decide whether to charge him an above-normal premium because he appears to be especially prone to accidents.
If any fact of the kind described is not disclosed by the proposer,or if any fact is misstated,even unintentionally,
the insurer is entitled to refuse to pay a claim under the policy.
Insurers maintain that this is only right because the proposer knows the facts and the insurer does not.
The insurer needs to be put in a fair position to decide whether to accept an insurance and on what terms.