Insurance is a social device that makes it possible for an individual or an organization to substitute a small definite cost (the premium) for a large but uncertain loss, up to the amount of the insurance. Under this arrangement, the fortunate many who escape loss will help to compensate the unfortunate few who suffer loss.
Insurers keep the arrangement operating by mathematically anticipating the probable extent of losses and by accumulating premiums in order to pay the losses as they occur. Actuaries (experts in the mathematics of insurance) use mortality tables (in the case of life insurance) and other data on risk to forecast losses.
The terms of the agreement between the insured and the insurer are expressed in a contract (the insurance policy). Based on the type of "loss events" covered, insurance policies fall into three classifications: personal, including death and disability; property, usually possessions of the insured; and liability, involving the person or property of others.
Known to merchants and traders since the ancient world, insurance now flourishes in most parts of the world. Privately owned insurance firms constitute major industries in the United States, Canada, Britain, and in some other advanced Western nations. Many governments operate social insurance programs.
Principles of Insurance
All insurance is based on three principles: the sharing of losses, the participation of a large number of people, and the equality of risk.
These principles can be illustrated with a simple example. Twenty men own houses that are identical in construction and value. The men come to an agreement to chip in and pay the owner's loss if one of the houses should happen to be destroyed by fire.
If one of the houses is destroyed by fire, each man's share will probably be greater than the individual participants can pay. The hardship will be especially severe if two members of the group lose their houses in the same year. The members will have to double their payments to cover both losses. However, if the group included 200 homeowners, the total loss of one man's house would require only one-tenth as much money from each member of the group.
In any practical insurance plan there must be enough loss sharers to protect the group from a sudden increase in losses from one year to the next. Also, enough people must be willing to pool the risks so that they can survive catastrophic losses, such as from
hurricanes, affecting many members of the group.
If, in the original example, some of the houses were made of brick, while others were of wood frame construction, risk sharing would be complicated. The risk of fire is not as great to a brick house as to a frame house. A risk-sharing arrangement based on equal contributions from each member would be unfair to the owner of a brick house. By the law of averages he would have to pay for more losses than he would face himself. His share of the payments should be proportionate to the risk that he faces.
Distribution of Insurance
The distribution structure in private insurance consists of insurers, field organizations, and associations. Insurers assume and pool risks, collect premiums, and pay losses. Field organizations sell insurance to the public and handle losses.
Associations are either intercompany (concerned with a variety of functions including activities designed to promote, directly or indirectly, the interests of insurers) or composed of agents (designed to promote the interests of insurer representatives who sell insurance to the public).
Insurers may be classified into two broad categories: (1) those organized as proprietary enterprises, including individual underwriters, syndicates of underwriters, and corporations organized on a capital stock basis; and (2) those organized as cooperative enterprises, including cooperatives organized on a mutual basis, associations, and reciprocals or interinsurance exchanges.
Lloyd's of London is the only significant insurer now operating through individual underwriters and syndicates of individuals. The capital stock and mutual insurers (organized as corporations) are the dominant organizations providing all forms of private insurance. A mutual company is owned, operated, and controlled by its policyholders. There are no stockholders, and no capital stock is issued. People become members of a mutual company by purchasing an insurance policy from it. Officers who run the company are appointed by a board of directors elected by policyholders. In a stock company, the stockholders elect the board of directors, which in turn appoints officers who manage the day-to-day affairs of the insurer.
Corporations operating a mutual plan of insurance generally dominate the field of life and health insurance; stock insurers dominate the property and liability fields. Although mutuals play a lesser role in property insurance generally, they have become a growing factor in liability insurance, particularly in the United States.
A reciprocal or interinsurance exchange is similar to, but not identical with, a mutual. Each policyholder in a reciprocal agrees to insure part of the risk of each policyholder in the exchange. The reciprocal itself is not liable to policyholders but they are liable to each other. The exchange is managed by an attorney-in-fact under direction of the policyholders. The exchange holds and invests assets contributed by the policyholders as premiums, but often they are credited to the account of the individual policyholder. In a mutual insurer, on the other hand, assets and holdings belong to the corporation, and the mutual corporation is liable to policyholders. Reciprocals are an American innovation in insurance, but they play a very small role in the overall distribution of insurance.
Specialized types of insurers, such as Blue Cross and Blue Shield Associations and other plans, are organized on a nonprofit basis to provide hospital and medical benefits for private groups. Government insurers vary in financial and operational details, but all, in one way or the other, carry out the various functions of insurers.
A number of agency arrangements have evolved for distributing insurance. Most life insurers contract with an agent to represent them exclusively and compensate him with commissions. In the life insurance field this is sometimes referred to as the "American agency system". Many companies using this system do not insist that their company be the only one represented by the agent, but some do. Some life insurance companies do not use commission agents but employ salaried representatives.
Although few life insurance companies rely on them exclusively, many companies place business through brokers. A broker represents the insured as a buyer of insurance instead of representing a company or companies as an agent.
There are three systems for distributing property insurance: (1) the American agency system, (2) salaried representatives, and (3) exclusive agents paid by commission. The American agency system in the property insurance field differs from that in life insurance. The agent does not represent only one company but is an independent businessman who represents several insurers. He is compensated solely by a commission on the business he places with a company. Some insurers, on the other hand, have salaried representatives who call on customers and prospective customers. These are sometimes referred to as "direct writers". Others have agents who represent only their company and are compensated by commissions. The latter companies are sometimes called "exclusive agency" companies.
In addition to selling, field organizations inspect property, to some extent handle underwriting, and investigate and settle claims. Home offices of insurers may, of course, maintain direct contact with the public through their own salaried employees. Branch offices, or sometimes franchised general agencies, usually provide field sales management services. Only in the United States has the insurance agent become a full-time practitioner. Elsewhere in the world direct selling and the use of part-time agents remain the rule.
The tendency toward association is highly developed in the insurance business. This tendency arises from the highly technical character of various aspects of insurance operations and from the desire of groups within the business to establish and maintain standards. Further, a desire to provide protection against damaging legislation leads to insurer and agent association activities. Such associations have played a major role in improving the quality of service provided by the insurance business and in lowering insurance costs to the public.