insurance

insurance, a system under which the insurer, for a consideration usually agreed upon in advance, promises to reimburse the insured or to render services to the insured in the event that certain accidental occurrences result in losses during a given period. It thus is a method of coping with risk. Its primary function is to substitute certainty for uncertainty as regards the economic cost of loss-producing events.

Insurance relies heavily on the “law of large numbers.” In large homogeneous populations it is possible to estimate the normal frequency of common events such as deaths and accidents. Losses can be predicted with reasonable accuracy, and this accuracy increases as the size of the group expands. From a theoretical standpoint, it is possible to eliminate all pure risk if an infinitely large group is selected.

From the standpoint of the insurer, an insurable risk must meet the following requirements:

1. The objects to be insured must be numerous enough and homogeneous enough to allow a reasonably close calculation of the probable frequency and severity of losses.

2. The insured objects must not be subject to simultaneous destruction. For example, if all the buildings insured by one insurer are in an area subject to flood, and a flood occurs, the loss to the insurance underwriter may be catastrophic.

3. The possible loss must be accidental in nature, and beyond the control of the insured. If the insured could cause the loss, the element of randomness and predictability would be destroyed.

4. There must be some way to determine whether a loss has occurred and how great that loss is. This is why insurance contracts specify very definitely what events must take place, what constitutes loss, and how it is to be measured.

From the viewpoint of the insured person, an insurable risk is one for which the probability of loss is not so high as to require excessive premiums. What is “excessive” depends on individual circumstances, including the insured’s attitude toward risk. At the same time, the potential loss must be severe enough to cause financial hardship if it is not insured against. Insurable risks include losses to property resulting from fire, explosion, windstorm, etc.; losses of life or health; and the legal liability arising out of use of automobiles, occupancy of buildings, employment, or manufacture. Uninsurable risks include losses resulting from price changes and competitive conditions in the market. Political risks such as war or currency debasement are usually not insurable by private parties but may be insurable by governmental institutions. Very often contracts can be drawn in such a way that an “uninsurable risk” can be turned into an “insurable” one through restrictions on losses, redefinitions of perils, or other methods.

Two main types of contracts—homeowner’s and commercial—have been developed to insure against loss from accidental destruction of property. These contracts (or forms) typically are divided into three or four parts: insuring agreements, identification of covered property, conditions and stipulations, and exclusions.

Homeowner’s insurance covers individual, or nonbusiness, property. Introduced in 1958, it gradually replaced the older method of insuring individual property under the “standard fire policy.”

In homeowner’s policies, of which there are several types, coverage can be “all risk” or “named peril.” All-risk policies offer insurance on any peril except those later excluded in the policy. The advantage of these contracts is that if property is destroyed by a peril not specifically excluded the insurance is good. In named-peril policies, no coverage is provided unless the property is damaged by a peril specifically listed in the contract.

In addition to protection against the loss from destruction of an owner’s property by perils such as fire, lightning, theft, explosion, and windstorm, homeowner’s policies typically insure against other types of risks faced by a homeowner such as legal liability to others for injuries, medical payments to others, and additional expenses incurred when the insured owner is required to vacate the premises after an insured peril occurs. Thus the homeowner’s policy is multi-peril in nature, covering a wide variety of risks formerly written under separate contracts.

Homeowner’s forms are written to cover damage to or loss of not only an owner’s dwelling but also structures (such as garages and fences), trees and shrubs, personal property (excluding certain listed items), property away from the premises (such as boats), money and securities (subject to dollar limits), and losses due to forgery. They also cover removal of debris following a loss, expenditures to protect property from further loss, and loss of property removed from the premises for safety once an insured peril has occurred.

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Flooding of a residential neighbourhood in New Orleans caused by Hurricane Katrina, August 2005.

Paul Morse/The White House

Recovery under homeowner’s forms is limited to loss due directly to the occurrence of an insured peril. Losses caused by some intervening source not insured by the policy are not covered. For example, if a flood or a landslide, which usually are excluded perils, severely damages a house that subsequently is destroyed by fire, the homeowner’s recovery from the fire is limited to the value of the house already damaged by the flood or landslide.

Recovery under homeowner’s forms may be on the basis of either full replacement cost or actual cash value (ACV). Under the former, the owner suffers no reduction in loss recovery due to depreciation of the property from its original value. This basis applies if the owner took out coverage that is at least equal to a named percentage—for example, 80 percent—of the replacement value of the property.

If the insurance amount is less than 80 percent, a coinsurance clause is triggered, the operation of which reduces the recovery amount to the value of the loss times the ratio of the amount of insurance actually carried to the amount equal to 80 percent of the value of the property. However, the reduced recovery will not be less than the “actual cash value” of the property, defined as the full replacement cost minus an allowance for depreciation, up to the amount of the policy. For example, assume that a property is valued at $100,000 new, has depreciated 20 percent in value, insurance of $60,000 is taken, and a $10,000 loss occurs. The actual cash value of the loss is $8,000 ($10,000 minus 20 percent depreciation). The operation of the coinsurance clause would limit recovery to 6 8 of the loss, or $7,500. However, since the actual cash value of the loss is $8,000, this is the amount of the recovery.

Recovery under homeowner’s forms is also limited if more than one policy applies to the loss. For example, if two policies with equal limits are taken out, each contributes one-half of any insured loss. Loss payments also are limited to the amount of an insured person’s insurable interest. Thus, if a homeowner has only a one-half interest in a building, the recovery is limited to one-half of the insured loss. The co-owners would need to have arranged insurance for their interest.