Originating in companies that insured merchant cargoes carried on the high seas, the American insurance business has grown into a complex, multitrillion-dollar industry that protects almost every conceivable asset threatened with possible loss.
A financial device used to manage risk, insurance works on the principle of pooling, which allows members of groups to share the risk of losses to individual members. Insurance allows pooling by collecting relatively small sums, called premiums, from each group member to establish reserves to be used to pay the losses of any member. Payments made after losses are incurred are called indemnities, and the process is called indemnification. Through insurance systems, each covered individual’s risk of loss is shared by the group.
Fire insurance illustrates the principle of pooling. If a house is worth $100,000 and there is a one-in-one-thousand chance that it and other houses like it may burn down in any given year, one thousand homeowners who each pay a premium of $100 would collectively cover the costs of rebuilding one home destroyed by fire. Thus, for the payment of a $100 premium each, individual homeowners would avoid the risk of losing the entire value of their homes to fire. However, the actual calculation of risks and the setting of premiums is naturally much more complicated than in this illustration. Insurance companies gather information to make such decisions and invest the premiums. In exchange for their efforts, they earn profits.
Insurance is available for many kinds of risks. For example, life insurance helps reduce the financial consequences of death. Health insurance addresses the risk of injury or disease. Property insurance may cover damages due to windstorms or hail, explosions or riots, and theft or fire. Liability insurance provides a defense and can pay settlements or judgments in the event of lawsuits.
Since the development of the concept of owned property in early human societies, managing risks associated with property ownership has been an issue. Whether that has been the personal ownership of the property and the desire to protect the property from damage, loss, or theft, or materials produced and sold to others that derive a livelihood for a business, some form of guarantee has always been in demand. In early times, those who had the wealth were able to provide assurance to those receiving the goods that they would be delivered as stipulated. To insure was to provide a guarantee to the parties involved that the transaction would take place as agreed upon.
Great Britain, which has long been heavily involved in maritime trade, pioneered commercial insurance and created the types of insurance companies that were established in North American colonies. During the American colonial era, insurance companies were designed to make profits, and many early companies profited at the expense of others by placing many restrictions and barriers for parties to be indemnified for their losses. After the American colonies became independent, churches tended to take over the insurance business in the United States, and the concept of classifying risks began. Insurance companies assessed the possibilities of loss due to fire and other “acts of God,” as well as losses to theft or damage. They even began placing values on the loss of life, in the form of life insurance.
During the nineteenth century, many enterprises found it necessary to protect both their employees and their companies against losses due to injuries to workers on the job and against claims of customers who suffered losses because of defective products that were the result of negligence on the part of the companies. Insurance to compensate workers for their losses was created, along with new forms of health, disability, and life insurance. Much of this was offered by fraternal organizations to their members. As risks were identified and defined, insurance policies were developed to cover those risks. Insured parties paid premiums to insurance companies to obtain the protection they desired.
Insurance companies found ways to collect premiums from many parties, while paying out benefits to few. The insurers created the means of underwriting such risks–knowing that some categories of risks and individuals or businesses were more likely to require compensation for losses than others. Through analysis of statistics and probability theory, companies determined rate structures that allowed them to collect premiums from large categories of customers, knowing they would not have to pay out the same amount collected to all people within that group. That shared risk philosophy was the beginning of a very lucrative industry.
The insurance industry is made up of hundreds of companies and thousands of agents who represent the companies. Captive agents may sell policies only for the companies that employ them and their subsidiaries. Independent agents sell policies for multiple companies and may be better placed to offer the insurance that individual parties need. Most agents are multiline providers who sell all types of insurance policies–automobile, home, commercial, life, health, and long-term care. Some agents concentrate on single lines, such as health insurance, life insurance, or a combination of both. Most companies pay their agents salaries, commissions, or combinations of both and typically offer bonus plans tied into company growth, company loss ratios, and retention of customers. Some companies have moved away from commission systems to keep premiums lower. To some extent, this change is a response to the rise of the Internet, which has helped consumers become more knowledgeable about insurance and made it easier for them to find the best deals.
The key to the construction of insurance is based around indemnification–the restoration of policyholders to the condition they enjoyed before their losses. Many insurance policies are designed to have the insurers act as third parties, taking care of losses after deductible or copayment requirements have been satisfied. Deductible provisions require the insured parties to share risks, thereby reducing the cost of the insurance premiums. Indemnification clauses prevent insured parties from profiting from losses. However, people soon learned that it was difficult to collect when a loss occurred, while many others framed their losses to comply with the policies in place. This would lead to a form of governmental regulation of the insurance industry.
The insurance industry is one of the most regulated businesses in the United States. Government regulation of the industry began in Europe during the nineteenth century. Because insurance policies are legal contracts, their wording is generally very complicated and often must be interpreted by courts. As the main concern of government should be to protect the interests of its citizens, ambiguous language in insurance contracts is generally interpreted against the makers of the contracts and in favor of the policyholders.
Government took on the role of wearing many hats to help better manage the American insurance industry during the early twentieth century. The role of compliance and oversight looked at many areas. These included ensuring that insurance companies have adequate reserves in place to pay possible claims, ensuring that rates being charged are not excessive, and protecting consumers against fraudulent acts of companies and their representatives. The federal government plays a role in public policy and political posturing by insurance companies, but most regulation of the industry occurs at the state level.
Every U.S. state has an insurance commissioner who seeks continuity and consistency through their National Association of Insurance Commissioners organization. Although the insurance laws vary among the states, insured parties have the comfort of knowing that their policies cover their property, regardless of in which state they may be. As insured parties move from one state to another, companies typically simply transfer coverage from one location to another, charging whatever is the appropriate risk premium for the new location. State-based regulation is seen as the strength of the American insurance industry in many ways.
Some insurance policies are underwritten solely by the federal government, although managed and directed through individual agents. A primary example is flood insurance. The federal government’s National Flood Insurance Program allows individuals and businesses in flood-prone areas to buy insurance policies that protect them against flood-caused losses.
Other catastrophic perils that may have exclusivity by companies include hurricane and earthquake policies. Because such natural hazards tend to be geographically isolated, it is difficult to spread the risks among many parties: People who live outside hurricane regions do not need to buy hurricane insurance, but people who live within such regions face high risks. Consequently, premiums for such insurance tend to be so high that some people forego insurance coverage. Hurricanes caused about $25 billion in damage in the United States during the year 2004, making that year the worst in U.S. hurricane history. In 2006, only two years later, the Gulf Coast was ravaged by Hurricane Katrina, which caused damage estimated at nearly $100 billion.
Although many people associate insurance primarily with personal and family protection, many insurance companies also protect commercial businesses from the same perils that threaten individuals and also offer additional protection for liability. Many industries have created risk-management divisions that help businesses identify risks that may potentially ruin them and find the means to protect them from possible losses. Although insurance is the main tool used to provide protection from many perils, businesses can also eliminate, transfer, or absorb portions of such risks to help keep their insurance costs down.
A modern twist in the insurance industry is the use of
Reinsurance takes one of two forms–proportional or nonproportional. In the proportional construction, it is a shared quota based on a percentage. Insurance companies can have a reinsurance company take on a percentage of any catastrophic loss. For example, if a company incurring tens of millions of dollars in losses from a hurricane were to have a proportional plan of 50 percent, it would be obligated for only 50 percent of those losses. The other 50 percent would be taken on by the reinsurance company. The nonproportional form of reinsurance is similar to a deductible, in which the company’s policy would come into a play only after a certain level of losses were reached. For example, if a company with a $3 million reinsurance policy with a $1 million retention were to incur a $2 million loss, it would pay out the first $1 million and its reinsurance company would pay the remaining $1 million.
Throughout its history, the American insurance industry has grown greatly, not only in size but also in complexity. The modern industry now offers many hundreds of types of insurance policies to individuals and businesses. These range from automobile and aviation policies to identity theft and terrorist protection policies. Hundreds of companies and their representatives are licensed and regulated to conduct business in the states in which they operate. These companies work with both federal and state government agencies to provide constantly changing insurance services.
Altman, E. The Financial Dynamics of the Insurance Industry. New York: Irwin Professional, 1994. Analysis of the American insurance industry that explores opportunities and challenges from insolvency to asset allocation. Harrington, Scott E., and Gregory Niehaus. Risk Management and Insurance. 2d ed. Boston: McGraw-Hill, 2004. Textbook on insurance law offering the essential aspects of insurance contracts and the insurance industry while providing a substantial conceptual analysis and attention to business risk management and public policy issues. Jenkins, David, and Takau Yoneyama. History of Insurance. 8 vols. Brookfield, Vt.: Pickering & Chatto, 2000. Collection of primary documents on the history of insurance in Great Britain through the nineteenth century. Jerry, Robert H., II. Understanding Insurance Law. 4th ed. Newark, N.J.: Lexis Nexis/Matthew Bender, 2007. Up-to-date textbook that is an eminently readable book about insurance law. Keeton, Robert E., and Alan I. Widiss. Insurance Law: A Guide to Fundamental Principles, Legal Doctrine, and Commercial Practices. St. Paul: West, 1988. Old but still widely used single-volume reference work on insurance law. Murray, John E. Origins of American Health Insurance: A History of Industrial Sickness Funds. New Haven, Conn.: Yale University Press, 2007. Well-regarded revisionist history of Progressive-era industrial sickness funds, when efforts were made to enact government health insurance.
Federal Deposit Insurance Corporation
Health care industry
Medicare and Medicaid
Pension and retirement plans
Social Security system
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