Overview: Insurance

What It Means

Insurance is an agreement that guarantees an individual, company, or other entity against the loss of money. Insurance agreements, sold by insurance companies, are called policies. An insurance policy stipulates that the company agrees to compensate the insured individual (or other entity) for potential future losses of such things as health, home, or car, in exchange for the regular payment of fees called premiums.

The purpose of insurance is to protect the financial well-being of an individual, company, or other entity in the case of an unexpected loss, such as damage to a building or the loss of health because of illness or injury. State and federal governments can mandate that some kinds of insurance, such as automobile insurance, be held; other types are optional.

Any risk that can be quantified in some manner most likely has a type of insurance to protect it. The most common kinds of insurance are medical, automobile, home, and life insurance. Once the insured policyholder pays the required premiums, medical insurance will provide the policyholder with financial support (usually the full or partial coverage of doctor, hospital, and pharmaceutical charges related to medical care) if medical treatment for an illness or injury is required. Automobile insurance provides financial support in the event of an automobile accident that damages the vehicle of the policyholder or of someone else. Life insurance guarantees payment to the beneficiaries if the insured person dies.

When an insured individual or company suffers a loss, they file a report, called a claim, to the insurer for amount of the loss. When the insurance company reimburses the insured (or directly pays for the charges) the reimbursement comes out of a fund to which many policyholders have contributed premiums. That way, when the insurance company needs to pay for an individual loss, the burden of paying it is divided among many insurance holders and does not fall heavily on the individual or entity who has incurred a loss. The challenge for insurance companies is to set aside enough money for anticipated losses so that they have profits resulting from whatever is left over, called the margin.

Different insurance policies establish different terms of agreement. Typically a policy will state the prices of the insured person’s premiums, how frequently they need to be paid, who should receive payment in case the insured dies, what types of loss events are covered and the time period of coverage, and how much the company will reimburse. Policies typically state that the policyholder is responsible for paying a part of the loss, known as a deductible, and that the insurer will pay what remains.

When Did It Begin

The essential concepts of insurance have been in existence for thousands of years. Whenever people have helped one another in the event of a loss, the idea of insurance has essentially been enacted. For example, if a house is damaged in a storm, the neighbors of the owner might step in to help rebuild. If they did, the owner would then have an incentive to help his neighbor, or potentially face not having his neighbor’s assistance in a future loss.

Early agreements to share or distribute the risk for certain types of losses were used by Chinese and Babylonian traders as far back as 3000 bc. Chinese merchants would divide the wares they were shipping among many boats in order to limit the amount of loss they would suffer if one or two ships capsized or could not complete the journey. In ancient Babylon merchants could pay fees to take out special loans stipulating that, if the ship or cargo was lost at sea, the merchant did not have to repay the loan; this protected the merchant from going into debt.

The ancient Greeks and Romans organized guilds called benevolent societies, which paid funeral expenses and cared for the families of its members when they died. These guilds, along with those in the Middle Ages (the period from about the fifth to the fifteenth century) that functioned in similar ways, were the foundation of modern health and life insurance.

In the fifteenth and sixteenth centuries, when ships from Europe began sailing for the Americas, marine insurance, which protected cargo and vessels in case they capsized, became useful and popular. After the Great Fire of London in 1666, in which thousands of buildings were destroyed, fire insurance was developed. The first fire-insurance company in the United States was founded in 1752 by Benjamin Franklin (1706–90). Franklin also helped establish the first life insurance company in 1759.

More Detailed Information

Insurance companies must carefully screen potential customers in order to make sure that the risks of certain customers are not too great. For instance, automobile insurers check a person’s driving record before issuing them a policy. Insurance companies rely on several criteria that help them determine whether or not it is in their best interest to insure specific events. Mainly, they must have confirmation that enough similar instances of potential loss exist; knowing that they do guarantees that the company can predict what it will have to cover. Companies must have assurance of predictability before they can risk the promise of protection.

Additionally, insurance companies must know that the amount of loss they will cover has a limit (meaning it must be “noncatastrophic”), even if it is very high, because they cannot afford to be jeopardized by unpredictable losses of massive proportions. Insurers typically seek to avoid drastic losses of their own financial reserves by purchasing reinsurance (insurance for insurance companies).

Insurance companies also require the loss events of their customers to be definite, measurable in financial terms, and located at a specific time and place. For instance, if an apartment renter is robbed and seeks reimbursement from the insurance company that sold him his rental insurance, he must be able to document such things as the date of the robbery, the report filed with police, and the value of the stolen property. Insurance companies must be sure that the loss of property was not intentional.

Insurers select the risks they will insure and determine the costs of the premiums that will cover them through a process known as underwriting. Underwriters draw on enormous files of data to research adverse events and develop predictions of the chances that claims will be filed against them. Attempting to maintain a balance between low-risk and high-risk individuals in the pool of insured candidates, underwriters carefully consider such things as each applicant’s potential for physical or psychological risk. The tasks of underwriting are complex, challenging, and crucial to the process of creating reliable insurance policies.

Another type of professional critical to the business of insuring people is an actuary. Actuaries are trained to use mathematical and statistical methods to assess various risks, and insurance companies employ them to help to determine potential risks and losses. For example, in determining the prices for life insurance policies, an actuary would analyze mortality models, which illustrate, for persons of each age, what the probability is that they die before their next birthday. In determining the prices for health insurance policies, an actuary would focus on statistical models showing rates of disability, morbidity (illness), mortality, and fertility.

One of the most commonly held types of insurance is life insurance. It was originally created to protect an individual’s family when his or her death left the surviving family without income. Over time, various life insurance policy plans have evolved. With a “whole life” policy, the insured person pays premiums of a fixed amount throughout his or her lifetime, and the money deposited accumulates interest (fees paid to the customer by the company; interest is usually calculated as a percentage of the amount in the account). At the time of the insured’s death, the insurance company pays the amount that has accumulated, in addition to the interest it has earned, to someone previously designated as the beneficiary (recipient of benefits). Even if the insured had ended the policy while alive, the benefit is still paid.

In a “universal life” policy, the insured individual can vary the amount and the timing of the premiums he or she pays to the company; the funds accumulate over time to create what is called the death benefit. A “variable life” policy allows fixed premiums to be invested in a portfolio (a selected group) of investments. As the premiums earn interest, the interest payments are put back into the portfolio, which increases the total amount that is invested; the death benefit is based on the performance of the investment. In a “term life” policy, the insurance coverage is for a specified time period, such as 10 to 15 years. In this type of plan, the value of the policy does not build up over its term.

Another type of insurance that many people, businesses, schools, and other organizations hold is fire insurance. Fire insurance usually protects against accidentally caused fires in the home that are damaging to property, as well as damage from lightening. Other types of insurance against natural elements are flood, tornado, hail, and drought insurance.

Recent Trends

Several developments in the twentieth century affected the insurance industry. In 1944 Congress took over the regulation of insurance companies, which had until that time been managed by the individual states. For the first half of the century, most U.S. insurance companies were only allowed to provide one type of insurance, but in the 1950s Congress passed legislation that allowed fire and casualty insurance companies to underwrite other types of insurance as well. As a result, many insurance companies expanded or merged to create enormous insurance corporations. Companies that provide multiple types of insurance—from auto, life, fire, and flood insurance to marine insurance (which protects boats) and credit insurance (which protects businesses against loss when customers fail to pay the amounts they owe)—are standard. Additionally, federal law had prohibited banks from entering into the insurance business, but in 1999 Congress repealed those laws. As a result, major banks have expanded into the insurance industry.