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7.1.2: A Brief Primer on Insurance

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    Insurance is our social and economic way of spreading the losses of a few across the greater population. We are pretty sure our house won’t burn down, but we buy fire insurance for the peace of mind that comes from knowing that on the odd chance that it does burn down, our investment would be protected. Our insurance premium is our contribution to setting things right for those few people whose houses do burn down since the house that burns down could be our own.


    Insurance is a business, but it’s also a product. There is a consumer’s market, insurance has value, and the product has a price—called the premium. But insurance differs from other products in that its cost to the company is determined only after it is sold. For this reason, the company tries hard to estimate in advance what that cost is likely to be.


    For an insurance company to stay in business, it must be able to: 

    1. Predict its potential losses.
    2. Calculate a price for premiums that will compensate for its losses and allow it to make a profit.
    3. Collect the premium.
    4. Pay off its claims as required in the insurance contract.

    The company has an executive department that determines overall corporate direction (including the basic decision about whether or not the company wants to be in the earthquake insurance business at all), a department that sends out your statement, a department that settles your claim, and a department that worries about risk so that the price of the premium fits the risk exposure of the company. This last process, called rating, is done by an actuary. To determine a rating for earthquake insurance for your house, the actuary may take into account the quality of construction, its proximity to known active faults, and the ground conditions. Underwriting is the determination of whether to insure you at all. The underwriter uses the rates established by the actuary and accepts the risk by establishing the premium. For example, if you are an alcoholic and have had several moving automobile violations, including accidents that were your fault, the underwriter might refuse your automobile insurance at any price. If a decision is made to insure you, the underwriter would establish the premium and deductible appropriate to the company’s risk exposure.


    An insurance company has reserves, money for the payment of claims that have already been presented but have not been settled, probably because the repair work has not yet been completed or the claim is in litigation. Reserves are not available for future losses; these losses show as a liability on the company’s books. A policyholder surplus, or net worth capital, or retained earnings are funds that represent the value of the company after all its liabilities (claims) have been settled. This is the money available to pay for future losses.


    It turns out that the insurance company, too, wants to hedge its bets against the future by transferring part of its risk to someone else. To meet this need, there are insurance companies that insure other companies—a process called reinsurance. Let’s say that the original company insures a multimillion-dollar structure but wants to spread the risk. So it finds another company to share that risk, and that company—a reinsurance company—then receives part of the premium. It might well be the reinsurance industry that is most interested in the results of scientists and engineers in earthquake probability forecasting and in assessing ground response to earthquake shaking.


    Some say that even the reinsurance industry would be unable to pay all claims arising from a catastrophic M 9 earthquake on the Cascadia Subduction Zone, and only the federal government, with its large cash reserves, can serve as the reinsurer of last resort. I return to this question later in the chapter.


    We start with that which insurance does best: insure against noncatastrophic losses such as auto accidents, fires, and death. These are called insurable risks. The loss must be definite, accidental, large, calculable, and affordable. Enough policies need to be written so that the Law of Large Numbers kicks in. The principle of indemnity (which excludes life insurance, of course) is to return the insured person or business to the condition that existed prior to the loss. This means replacing or repairing the property or paying out its value as established in the insurance contract. The contract might include both direct coverage, replacing the property that was damaged or destroyed, and indirect coverage, taking care of the loss of income in a business or loss of use of the property. Protection against liability might be included. The contract commonly contains a deductible clause, which states that the insurance company will pay only those losses exceeding an agreed-upon amount. The higher the deductible, the lower the premium. This reduces the risk of exposure for the company and reduces the number and paperwork of small claims submitted.


    The underwriter has calculated the exposure risk using the Law of Large Numbers. A lot of historical information about fire and auto accident losses is available, so the risk exposure is calculable; that is, the underwriter can recommend premium levels and types of coverage with considerable confidence that the company will be able to offer affordable coverage and still make a profit. The underwriter also looks for favorable factors that might reduce the risk. For fire insurance, a metal roof and vinyl siding would present less risk than a shake roof and wood siding. Auto insurance might include discounts for non-drinkers or for students with a grade-point average of B or better. The underwriter also looks for general trends, like the effect of a higher speed limit on auto accident risk (increasing risk exposure), or of laws requiring seat belts and child restraints in automobiles (reducing risk exposure).


    This page titled 7.1.2: A Brief Primer on Insurance is shared under a CC BY-NC-SA 4.0 license and was authored, remixed, and/or curated by Robert S. Yeats (Open Oregon State) via source content that was edited to the style and standards of the LibreTexts platform; a detailed edit history is available upon request.