Term
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Definition
Insurance is an economic device utilized by individuals and organizations to protect themselves against the risk of realizing unforeseen and extraordinary financial losses.
By purchasing an insurance policy from an insurance company, an individual or organization can transfer the financial risk of a potentially devastating loss to another party, called the insurer.
Insurer
A company selling insurance.
Insured
The individual or entity purchasing the insurance. |
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Term
Insurance is an economic device utilized by individuals and organizations to protect themselves against the risk of realizing unforeseen and extraordinary financial losses.
By purchasing an insurance policy from an insurance company, an individual or organization can transfer the financial risk of a potentially devastating loss to another party, called the insurer.
Insurer
A company selling insurance.
Insured
The individual or entity purchasing the insurance. |
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Definition
An insurance company operates by spreading the risk of experiencing a large unforeseen financial loss amongst a large group of people. An insurance company collects premiums from its group of policyholders, and places those premiums into a large pool of money.
When a policyholder experiences an unforeseen loss, that policyholder makes a claim against their insurance policy. The insurance company then pays the claim of the policyholder from funds collected in the large pool of money. Since only a small fraction of an insurance company's policyholders will experience a devastating loss over the course of their policy term, the pooled money should always be sufficient to pay for the individual losses amongst the group of policyholders.
For example, while an insurance company may collect premium payments from 100,000 auto insurance policyholders over a one-year period, odds are that only 3,000 of those policyholders will actually file a claim due to an auto accident. The insurance company then uses the premiums collected from 100,000 policyholders to pay the claims of the 3,000 people actually involved in accidents.
An insurance company ensures this pool of money is always sufficient by managing risk, |
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Term
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Definition
A contract is defined as a legally enforceable agreement between two or more persons or parties. In order for a contract to be legally binding, all the following conditions must be met:
Agreement- all parties to a contract must agree to the terms of a contract. This is usually specified by a signature to the terms of a contract.
Consideration- each party must contribute something of value to the contract.
Competent Parties- both parties must have the legal capacity to enter into a contract. Both parties must be 18 years of age for a contract to be enforceable, and both parties must be of proper mental capacity when they sign the contract.
Legal Purpose- the subject / subjects of a contract must be of legal purpose. |
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Term
| What is an Insurance Policy? |
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Definition
An insurance policy is a contract whereby an individual or an organization agrees to a pay a scheduled fee to an insurance company, and in return the insurance company promises to provide financial protection to the policyholder if certain defined events occur.
An insurance policy is a legally enforceable contract between an insurance company and a policyholder. An insurance policy meets the following conditions of a legally binding contract:
Agreement
The insurance company provides the insurance policy, and the applicant agrees to the policy by providing a signature on the policy.
Consideration
The insured party provides the premium, and the insurance company provides financial protection for the insured.
Competent Parties
The insured party, or policyholder must be 18 years of age and of proper mental capacity to enter into an insurance contract.
Legal Purpose
An insurance contract is of full and legal purpose. |
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Term
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Definition
Private insurance generally refers to stock or mutual insurance providers who sell an array of insurance products to consumers based on their individual buying preferences.
Consumers seek out private insurance companies to purchase insurance policies based on their own lifestyles and insurance needs and preferences. Private insurance companies are generally in business to turn a profit or supply insurance needs to their subscribers only. |
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Term
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Definition
Government insurance, commonly referred to as social insurance, is a program (usually mandatory) where risks are transferred to and pooled by a governmental entity that is then legally required to provide certain benefits. Government insurance is always a non-profit program.
Social insurance programs are characterized by:
Mandatory participation.
The benefits are prescribed by federal law.
They are designed to meet the best needs of the general public as a whole.
There is a monopolization by a government entity.
Some examples of government insurance include Social Security, Medicare, Medicaid, and the Federal Deposit Insurance Corporation. |
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Term
| What Are Private Commercial Insurers |
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Definition
Private commercial insurers are insurance companies that operate in order to return a profit.
Private commercial insurers are required to keep a defined amount of the collected policyholder premiums in reserve to pay for claims against their insurance policies.
Monies collected over and above the required reserves are returned to the insurance company as operating profit.
Examples include Aetna Insurance, AllstateInsurance, and Nationwide Insurance. |
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Term
| What are Private Non-Commercial Insurers? |
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Definition
Private Non-Commercial Insurers operate on a non-profit basis, and return profits to their policyholders through reduced premiums or expanded benefits.
Examples include Blue Cross and Blue Shield. |
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Term
| What is the Federal Government's Role? |
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Definition
The Federal Government is considered a special non-profit provider, and provides many types of insurance. Examples include Medicare, Medicaid, and the Federal Deposit Insurance Corporation.
As we stated earlier, government insurance programs are always non-profit enterprises, and is often referred to as social insurance. |
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Term
| Stock Vs. Mutual Insurance Providers. |
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Definition
Insurance companies can act as stock insurance companies or mutual insurance companies.
Stock insurance companies operate like any other publicly traded company. For example, any insurance company trading on the New York Stock Exchange, such as AFLAC, Allstate, Geico, Progressive to name a few.
Stockholders provide capital for the insurance company, and in turn the stockholders participate in the profits or losses of the company in the form of dividends.
Stock insurance companies are sometimes referred to as non-participating insurance companies, because the policyholders do not participate in dividends.
Many private commercial insurers are stock insurance companies. |
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Term
| Mutual insurance companies are owned by the insured, the policyholders.. |
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Definition
The policyholders act like stockholders in that they elect a board of directors to run the company, and participate in any positive gains or losses of the company through policy dividends.
Because the policyholders participate in the dividends, mutual insurance companies are known as participating insurance companies. |
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Term
| Risk Purchasing Group (RPG) |
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Definition
A risk purchasing group refers to a number of parties with similar insurance needs coming together to form an organization for the sole purpose of purchasing commercial liability insurance on a group basis.
A purchasing group does not take on the role of an insurer, and is therefore is not exposed to risk like an insurance company.
A purchasing group simply consists of a number of parties interested in purchasing insurance together. Members of a purchasing group must operate in similar or related businesses which expose them as a group to similar-type risks.
For example, a group of independent grocers may elect to establish an organization, or risk purchasing group, for the sole purpose of purchasing liability insurance for their small grocery stores. Independent grocers new to the business may then reach out to the risk purchasing group in order to learn about their insurance needs, and purchase insurance through the organization.
Risk purchasing groups are authorized by the Federal Liability Risk Retention Act of 1986. |
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Term
| Fraternal Benefit Societies |
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Definition
Fraternal Benefit Societies or Fraternal Associations are non-profit, mutual aid organizations that offer insurance to members and their families against death, disease and disability.
They primarily exist as social organizations that engage in charitable or benevolent activities. Fraternal benefit societies generally recruit their members through lodges, fraternal organizations and a variety of social groups who share common interests such as religious beliefs, occupations or ethnicities.
The Elks, the Masons, The Catholic Aid Association and Sons of Norway are examples of fraternal benefit societies. The altruistic efforts of fraternal benefit societies are primarily funded by the sale of financial services and life insurance to their members.
Fraternal benefit society insurance benefits are required by law to be assessable. The members are both providers and recipients of the benefits as a whole, and if the society's claims-paying ability becomes impaired, the members may be required to pay their share of the deficiency. |
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Term
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Definition
Fraternal Benefit Societies or Fraternal Associations are non-profit, mutual aid organizations that offer insurance to members and their families against death, disease and disability.
They primarily exist as social organizations that engage in charitable or benevolent activities. Fraternal benefit societies generally recruit their members through lodges, fraternal organizations and a variety of social groups who share common interests such as religious beliefs, occupations or ethnicities.
The Elks, the Masons, The Catholic Aid Association and Sons of Norway are examples of fraternal benefit societies. The altruistic efforts of fraternal benefit societies are primarily funded by the sale of financial services and life insurance to their members.
Fraternal benefit society insurance benefits are required by law to be assessable. The members are both providers and recipients of the benefits as a whole, and if the society's claims-paying ability becomes impaired, the members may be required to pay their share of the deficiency. |
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Term
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Definition
A reciprocal insurer is an unincorporated group of subscribers operating individually and collectively through an attorney-in-fact to provide reciprocal insurance benefits amongst themselves. More simply put, it is a group of people or organizations that insure each other. Reciprocal insurers are non-profit entities.
Essentially, each member of a reciprocal insurer pays their premium into an individual account. If any one of the members of the insurance group makes a claim for a loss, the cost of that loss is spread equally among all the other members of the group.
Each reciprocal insurer generally maintains an advisory group composed of subscribers who hire an attorney-in-fact to handle the administration, underwriting, sales, promotion and claims handling of the reciprocal insurer group. |
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Term
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Definition
The most famous example of a risk retention group is Lloyd's of London.
A risk retention group does not offer insurance in and of itself; rather it facilitates a group of its member individuals and/ or organizations who wish to offer insurance by providing their own capital. By providing their own capital, they risk losing their money or profiting personally if a claim is made against the policy issued.
Essentially, a number of wealthy individuals and/ or organizations will come together and form a syndicate.
This syndicate will then amass a pool of capital from voluntary investors, and utilize a risk retention group underwriter to write insurance policies against that pool of capital. The members of the syndicate are personally and financially responsible for paying out any claims against their pool of money, or collecting the profits.
The risk retention group simply provides a market and support for the insurance policy. It provides agents, brokers, underwriters and other administrative professionals, and assures full and adequate financial performance by it's members. |
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Term
| Characteristics of Insurance Contracts |
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Definition
Insurance contracts are contracts where an insurance company promises to pay an insured party if certain defined events occur.
Insurance contracts are designed to meet very specific needs, and thus have many characteristics not commonly found in non-insurance contracts.
In this section, we will examine some of the unique characteristics of insurance contracts. |
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Term
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Definition
An insurance contract is considered a personal contract.
While we often describe insurance in terms of "insuring our car" or "insuring our home," insurance contracts actually cover the person and their economic relationship with the insured item.
While technically you may agree purchase insurance on an "item", the insurance contract actually protects you, as a person, from the economic hardship of realizing financial damages to, or a loss of, the insured item.
Think about it this way. If you sold your car, does your insurance coverage follow your car, or does it follow you?
It follows you as a person. Hence, an insurance contract is considered a personal contract. |
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Term
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Definition
An insurance contract is classified as a contract of adhesion.
A contract of adhesion is a contract between two parties that offers the consumer little to no leeway to negotiate the terms of the contract.
A contract of adhesion implies an unequal balance of power in the creation of the contract. In the insurance industry, the insurer alone dictates the terms of the contract, and the consumer only has the option whether to take it or leave it. The consumer has no leeway in making material changes to an insurance contract.
Fortunately for the insurance consumer, this balance of power shifts to the insured during legal matters regarding the execution of the contract.
Any ambiguities in a contract of adhesion generally favor the insured party. Since the insurer enjoys the balance of power in the creation of the contract, they are expected to cover all their bases. Any holes in coverage, or discrepancies in the contract, will benefit only the consumer. |
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Term
| Utmost Good Faith Contracts |
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Definition
An insurance contract is considered a contract of utmost good faith. not utilized utmost good faith in divulging the full extent of the risks to the insurer, the insurer can void the contract.
Insurance contracts are agreed upon assuming the utmost good faith of each participating party. In insurance contracts, this particularly applies to the insured party. While the insurance company simply promises to pay, the insured has a duty to disclose, be truthful about, and be honest regarding all material facts related to the risk of being covered by an insurance contract.
Insurers deal with thousands of applicants for insurance policies, and couldn't possibly research the relevant details to every contract they sign. As such, they must trust that the applicant has utilized utmost good faith in revealing the true nature of the insurance risk.
If an insurer discovers the applicant has |
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Term
Characteristics of Insurance Contracts
Aleatory Contracts |
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Definition
An insurance contract is considered an aleatory contract.
Insurance contracts are considered aleatory contracts because the amounts exchanged over the course of the contract are usually unequal and depend upon the timing of the occurrence of unforeseen events.
The performance of the insurer is contingent upon the loss of, or damage to, an insured "unit." Once an insured unit has been damaged or destroyed, the insurer is contractually obligated to immediately respond to the insured party.
When the "specified event" actually occurs determines who benefits from the contract.
For example, a policyholder may pay premiums for years, yet never make a claim against their insurance contract. In this situation, the insurer benefits from the contract.
Conversely, a policyholder may make only one or two premium payments, and then make a claim worth hundreds of thousands, if not millions, of dollars to the insurance company. In this situation, the policyholder benefits from the policy. |
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Term
Characteristics of Insurance Contracts
Unilateral contracts |
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Definition
An insurance contract is considered a unilateral contract.
Most contracts are considered bilateral contracts, where both parties make promises to deliver to one another. For example, in a bilateral contract to sell a house, one person might promise to deliver $500,000 to the owner, and in turn the owner promises to turn over the title to the house.
A unilateral contract is a contract where only one of the participating parties makes a promise to perform.
Insurance contracts are unilateral contracts in that only the insurer makes a promise to pay on a claim, if only the relevant unforeseen event occurs.
An insurance contract essentially exchanges an act from the policyholder (paying a premium) for a promise, and the insurer may never have to perform on its end of the contract. |
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Term
Characteristics of Insurance Contracts
Conditional Contract |
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Definition
Insurance contracts are considered conditional contracts because certain conditions must be met in order for the contract to be enforceable.
Insurance contracts are conditional upon the occurrence of specified events that cause damages and / or a loss to insured items.
If the specified events, or "conditions," never occur, the contract will never be executed nor enforceable. |
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Term
What is risk?
Risk is defined as the potential for loss or injury. |
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Definition
Risk can have both positive and negative outcomes.
For example, every time we drive to the store we are taking a risk because we have the potential to get injured in an auto accident. By assuming the risk and driving to the store, we experience a positive outcome when we get to the store and back with the supplies we needed without an auto accident.
But if we had been involved in an accident during our trip to the store, our risk of driving obviously had a very negative outcome.
We will now analyze two different classifications of risk. |
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Term
What is risk?
Speculative risk |
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Definition
Speculative risk is a risk undertaken that results in an unknown degree of gain or loss. Speculative risks are conscious choices made by an individual. Investing in the stock market and gambling are considered speculative risks because we choose to enter into a situation that involves risk. We fully expect a negative outcome, but hope for a positive outcome.
Consider the purchase of a lottery ticket. When we purchase a lottery ticket, we make a conscious choice to purchase the ticket even though we have a very high risk of experiencing a loss. But, we also have the potential to experience a tremendous gain if we win the lottery.
Insurance companies do not insure speculative risks! |
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Term
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Definition
The second type of risk is called pure risk.Pure risk is a risk where a loss is the only possible outcome. Pure risk is related to events that are completely out of the risk-takers control. You do not choose to participate in a pure risk.
For example, if you choose to build a home in the State of Texas, you run a pure risk of having your home destroyed by a tornado. You don't choose to build your home in the path of a tornado, yet you still run a pure risk of a tornado destroying the house simply because tornadoes are prevalent in the State of Texas.
In our earlier example of driving to the store, we run a pure risk of having our car damaged during the drive. While we may experience a positive outcome by gathering our supplies, simply driving the car is a pure risk because the car itself will not benefit from the drive. Loss is the only possible outcome for the car during the drive.
Insurance companies only insure pure risks! |
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Term
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Definition
From an insurance company perspective, risk is always defined in terms of the potential for financial losses. The greater the potential financial loss, the greater the risk to the insurance company.
When we apply for an auto insurance policy from an insurance company, the insurer will always check our driving record to analyze our history of driving infractions. If we have a long list of speeding tickets, the insurer may realize that we engage in poor driving behaviors.
If we have a record of engaging in poor driving behavior, our risk of being involved in an auto accident climbs proportionately. As such, the insurance company realizes a much greater chance of having to pay for your poor driving habits, and will you consider you a high risk to insure. |
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Term
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Definition
Insurance companies utilize risk management to determine whether or not to write an insurance policy.
When an individual applies for an insurance policy, they are asking an insurance company to take on a financial risk. Now the insurance company must decide if it wants to take on that risk by assessing the possibility of taking a financial loss on the insured item.
Since most insurers are in business to make a profit, an insurance company obviously won't take on the financial risk of something very likely to be lost or destroyed. By insuring these high risk items, the insurer would not collect enough in premiums over the life of the policy to equal the amount of money paid out on the policy, and the insurer would lose money on the policy.
As such, insurers analyze risk to determine the likelihood whether or not they would lose money on a policy.
In order to understand how risk management works, we first need to understand some important terms associated with risk management. |
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Term
Risk Management concepts
Risk |
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Definition
To an insurance company, the risk pertains to the actual item, person, or organization that has been insured.
For example, when you purchase auto insurance, the insurance company would define the car as the risk.
When you purchase professional liability insurance, the insurance company would define you and your professional behavior as a risk.
When you purchase homeowners insurance, the insurance company defines your house and possessions as a risk.
Remember, the insurance company views a risk as the potential for a financial loss. In any of the above cases, insuring the item, person, or organization presents an opportunity for a financial loss if defined events transpire in relation to the risk and it is damaged or destroyed. Or, in the case of liability insurance, an individual unwittingly causes damage or destruction. |
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Term
Risk Management concepts
Loss |
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Definition
In insurance terms, loss refers to the ascertained financial liability of the insurer to indemnify (make whole) the policyholder. More simply put, loss refers to the amount of money an insurance company will have to pay to an individual to meet the promises outlined in the insurance contract.
If a tornado travels directly through your property, any damage or destruction to your home is considered a loss to the insurance company, as they now must pay you for the repairs needed to replace your damaged home. |
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