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Definition of Insurance
Insurance, in law and economics, is a form of risk management primarily used to transfer the risk of certain types of contingent loss from one entity to another in exchange for a premium. An insured is the entity that transfers away the risk. An insurer is the entity that accepts the risk. An insurer sets the premium in a variety of ways, involving a combination of formulae and judgement. Risk management, the practice of appraising and controlling risk, has evolved as a parallel field of study and practice.

Operationally, insurance is
 * the benefit provided by a particular kind of contract, called an insurance policy;
 * that is issued by one of several kinds of legal entities (stock insurance company, mutual insurance company, reciprocal, or Lloyd's syndicate, for example), any of which may be called an insurer;
 * in which the insurer promises to pay on behalf of or to indemnify another party, called a policyholder or insured,
 * in exchange for a payment or a promise of a payment called the premium;
 * where the policy protects the insured against loss caused by certain perils as defined in the policy.

Early Antecedants
In some sense, insurance began with the appearance of human society. We know of two types of economies in human societies: money economies (those with markets, money, financial instruments and so on) and non-money or natural economies (without money, markets, financial instruments and so on). Natural economies are a more ancient form than market economies. In a natural economy, insurance takes the form of people helping each other. For example, if a house burns down, the members of the community help build a new one. There is an implicit resciprocity; neighbors help each other to hedge againt the time they need help themselves.

Emergence of Modern Insurance
As civilization emerged and expanded, early methods of transferring or distributing risk were practiced by Chinese and Babylonian traders as early as the 3rd and 2nd millennia BC, respectively. Chinese merchants travelling treacherous river rapids would redistribute their wares across many vessels to limit the loss due to any single vessel's capsizing. The Babylonians developed a system recorded in the Code of Hammurabi, c. 1750 BC, and practiced by early Mediterranean sailing merchants. If a merchant received a loan to fund his shipment, he would pay the lender an additional sum in exchange for the lender's guarantee to cancel the loan should the shipment be stolen. A thousand years later, the inhabitants of Rhodes invented the concept of the 'general average'. Merchants whose goods were being shipped together would pay a proportionally divided premium which would be used to reimburse any merchant whose goods were jettisoned during storm or sinkage.

The Greeks and Romans introduced the origins of health and life insurance c. 600 AD when they organized guilds which cared for the families and paid funeral expenses of members upon death. Guilds in the Middle Ages served a similar purpose. The Talmud deals with several aspects of insuring goods. Before insurance was established in the late 17th century, "friendly societies" existed in England, in which people donated amounts of money to a general sum that could be used for emergencies.

Separate insurance contracts (i.e., insurance policies not bundled with loans or other kinds of contracts) were invented in Genoa in the 14th century, as were insurance pools backed by pledges of landed estates. These new insurance contracts allowed insurance to be separated from investment, a separation of roles that first proved useful in marine insurance. Insurance became far more sophisticated in post-Renaissance Europe, and specialized varieties developed.

Toward the end of the seventeenth century, London's growing importance as a center for trade increased demand for marine insurance. In the late 1680s, Mr. Edward Lloyd opened a coffee house that became a popular haunt of ship owners, merchants, and ships’ captains. It was therefore seen as a reliable source of the latest shipping news. It became the meeting place for parties wishing to insure cargoes and ships, and those willing to underwrite such ventures. Today, Lloyd's of London remains one of the insurance leading markets, particularly for marine and certain specialty types of insurance.

Insurance as we know it today can be traced to the Great Fire of London, which in 1666 devoured 13,200 houses. In the aftermath of this disaster, Nicholas Barbon opened an office to insure buildings. In 1680, he established England's first fire insurance company, "The Fire Office," to insure brick and frame homes.

The first insurance company in the United States underwrote fire insurance and was formed in Charles Town (modern-day Charleston), South Carolina, in 1732.

Benjamin Franklin helped to popularize and make standard the practice of insurance, particularly against fire in the form of perpetual insurance. In 1752, he founded the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire. Franklin's company was the first to make contributions toward fire prevention. Not only did his company warn against certain fire hazards, it refused to insure certain buildings where the risk of fire was too great, such as all wooden houses.

Characteristics of insurable risks
Commercially insurable risks typically share seven common characteristics.


 * 1) A large number of homogeneous exposure units. Most insurance policies are provided to individual members of very large classes.  Automobile insurance, for example, covered about 175 million automobiles in the United States in 2004.  The existence of a large number of homogeneous exposure units allows insurers to benefit from the so-called “law of large numbers,” which in effect states that as the number of exposure units increases, the actual results are increasingly likely to become close to expected results.  There are exceptions to this criterion.  Lloyd's of London is famous for insuring the life or health of actors, actresses and sports figures.  Other examples include Satellite Launch insurance, certain large commercial properties for which there are no ‘homogeneous’ exposure units and the like.  Despite failing on this criterion, many exposures like these are generally considered to be insurable.
 * 2) Definite Loss. The event that gives rise to the loss that is subject to insurance should, at least in principle, take place at a known time, in a known place, and from a known cause.  The classic example is death of an insured on a life insurance policy.  Fire, automobile accidents, and worker injuries may all easily meet this criterion.  Other types of losses may only be definite in theory.  Occupational disease, for instance, may involve prolonged exposure to injurious conditions where no specific time, place or cause is identifiable.  Ideally, the time, place and cause of a loss should be clear enough that a reasonable person, with sufficient information, could objectively verify all three elements.
 * 3) Accidental Loss. The event that constitutes the trigger of a claim should be fortuitous, or at least outside the control of the beneficiary of the insurance.  The loss should be ‘pure,’ in the sense that it results from an event for which there is only the opportunity for cost.  Events that contain speculative elements, such as ordinary business risks, are generally not considered insurable.
 * 4) Large Loss. The size of the loss must be meaningful from the perspective of the insured.  Insurance premiums need to cover both the expected cost of losses, plus the cost of issuing and administering the policy, adjusting losses, and supplying the capital needed to reasonably assure that the insurer will be able to pay claims.  For small losses these latter costs may be several times the size of the expected cost of losses.  There is little point in paying such costs unless the protection offered has real value to a buyer.
 * 5) Affordable Premium. If the likelihood of an insured event is so high, or the cost of the event so large, that the resulting premium is large relative to the amount of protection offered, it is not likely that anyone will buy insurance, even if on offer.  Further, as the accounting profession formally recognizes in Financial Accounting Standards 113, the premium cannot be so large that there is not a reasonable chance of a significant loss to the insurer.
 * 6) Calculable Loss. There are two elements that must be at least estimable, if not formally calculable:  the probability of loss, and the attendant cost.  Probability of loss is generally an empirical exercise, while cost has more to do with the ability of a reasonable person in possession of a copy of the insurance policy and a proof of loss associated with a claim presented under that policy to make a reasonably definite and objective evaluation of the amount of the loss recoverable as a result of the claim.
 * 7) Limited risk of catastrophically large losses. The risk is often the result of  aggregation.  If the same event can cause losses to numerous policyholders of the same insurer, the ability of that insurer to issue policies becomes constrained, not by factors surrounding the individual characteristics of a given policyholder, but by the factors surrounding the sum of all policyholders so exposed.  Typically, insurers prefer to limit their exposure to a loss from a single event to some small portion of their capital base, on the order of 5 percent.  Where the loss can be aggregated, or an individual policy could produce exceptionally large claims, the capital constraint will restrict an insurers appetite for additional policyholders.  The classic examples are earthquake insurance in earthquake zones  and wind insurance in hurricane zones.  The normal response to such situations is syndication of the risk, although some aggregation risks are large enough to affect the world insurance and reinsurance market market.

When it Insurance actually Insurance?
Different jurisdictions answer the question 'what is insurance?' differently. The next two section describe and compare the answers given in the US under GAAP and in most of the rest of the world under IAS. Given the planned convergence of the two standards, both of which are under review by their respective Boards, it is possible that these differences will disappear over time.

Under US GAAP and SAP
In recent years the operational definition cited above proved inadequate as a result of contracts that had the form but not the substance of insurance. The essence of insurance is the transfer of risk from the insured to one or more insurers. How much risk a contract actually transfers proved to be at the heart of the controversy.

This issue arose most clearly in reinsurance, where the use of Financial Reinsurance to reengineer insurer balance sheets under US GAAP became fashionable during the 1980s. The accounting profession raised serious concerns about the use of reinsurance in which little if any actual risk was transferred, and went on to address the issue in FAS 113, cited above. While on its face, FAS 113 is limited to accounting for reinsurance transactions, the guidance it contains is generally conceded to be equally applicable to US GAAP accounting for insurance transactions executed by commercial enterprises.

Does the contract contain adequate risk transfer?
FAS 113 contains two tests, called the '9a and 9b tests,' that collectively require that a contract create a reasonable chance of a significant loss to the underwriter for it to be considered insurance. "9. Indemnification of the ceding enterprise against loss or liability relating to insurance risk in reinsurance of short-duration contracts requires both of the following, unless the condition in paragraph 11 is met:" "a. The reinsurer assumes significant insurance risk under the reinsured portions of the underlying insurance contracts." "b. It is reasonably possible that the reinsurer may realize a significant loss from the transaction."

Paragraph 10 of FAS 113 makes clear that the 9a and 9b tests are based on comparing the present value of all costs to the PV of all income streams. FAS gives no guidance on the choice of a discount rate on which to base such a calculation, other than to say that all outcomes tested should use the same rate.

Statement of Statutory Accounting Principles ("SSAP") 62, issued by the National Association of Insurance Commissioners, applies to so-called 'statutory accounting' - the accounting for insurance enterprises to conform with regulation. Paragraph 12 of SSAP 62 is nearly identical to the FAS 113 test, while paragraph 14, which is otherwise very similar to paragraph 10 of FAS 113, additionally contains a justification for the use of a single fixed rate for discounting purposes. The choice of an "reasonable and appropriate" discount rate is left as a matter of judgment.

Is there a brightline test?
Neither FAS 113 nor SAP 62 defines the terms reasonable or significant. Ideally, one would like to be able to substitute values for both terms. It would be much simpler if one could apply a test of an X percent chance of a loss of Y percent or greater. Such tests have been proposed, including one famously attributed to an SEC official who is said to have opined in an after lunch talk that a 10 percent chance of a 10 percent loss was sufficient to establish both reasonableness and significance. Indeed, many insurers and reinsurers still apply this 10/10" test as a benchmark for risk transfer testing.

It should be obvious that an attempt to use any numerical rule such as the 10/10 test will quickly run into problems. Implicit in the test is keeping the 10/10 that either are upper bonds for the comment made by the SEC official therefore, the rest of this paragraph doesn't apply. Suppose a contract has a 1 percent chance of a 10,000 percent loss? It should be reasonably self-evident that such a contract is insurance, but it fails one half of the 10/10 test.

It does not appear that any brightline test of reasonableness nor significance can be constructed.

Excess of loss contracts, like those commonly used for umbrella and general liability insurance, or to insure against property losses, will typically have a low ratio of premium paid to maximum loss recoverable. This ratio (expressed as a percentage), commonly called the rate on line for historical reasons related to underwriting practices at Lloyd's of London, will typically be low for contracts that contain reasonably self-evident risk transfer. As the ratio increases to approximate the present value of the limit of coverage, self-evidence decreases and disappears.

Contracts with low rates on line may survive modest features that limit the amount of risk transferred. As rates on line increase, such risk limiting features become increasingly important.

"Safe harbor" exemptions
The analysis of reasonableness and significance is an estimate of the probability of different gain or loss outcomes under different loss scenarios. It takes time and resources to perform the analysis, which constitutes a burden without value where risk transfer is reasonably self-evident.

Guidance exists for insurers and reinsurers, whose CEO's and CFO's attest annually as to the reinsurance agreements their firms undertake. The American Academy of Actuaries, for instance, identifies three categories of contract as outside the requirement of attestation:


 * Inactive contracts. If there are no premiums due nor losses payable, and the insurer is not taking any credit for the reinsurance, determining risk transfer is irrelevant.
 * Pre-1994 contracts. The attestation requirement only applies to contracts that were entered into, renewed or amended on or after 1 January 1994.  Prior contracts need not be analyzed.
 * Where risk transfer is "reasonably self-evident."

"'Risk transfer is reasonably self-evident in most traditional per-risk or per-occurrence excess of loss reinsurance contracts. For these contracts, a predetermined amount of premium is paid and the reinsurer assumes nearly all or all of the potential variability in the underlying losses, and it is evident from reading the basic terms of the contract that the reinsurer can incur a significant loss. In many cases, there is no aggregate limit on the reinsurer's loss.  The existence of certain experience-based contract terms, such as experience accounts, profit commissions, and additional premiums, generally reduce the amount of risk transfer and make it less likely that risk transfer is reasonably self-evident.'"


 * - "Reinsurance Attestation Supplement 20-1: Risk Transfer Testing Practice Note," American Academy of Actuaries, November 2005. ...

Risk limiting features
An insurance policy should not contain provisions that allow one side or the other to unilaterally void the contract in exchange for benefit. Provisions that void the contract for failure to perform or for fraud or material misrepresentation are ordinary and acceptable.

The policy should have a term of not more than about three years. This is not a hard and fast rule. Contracts of over five years duration are classified as ‘long-term,’ which can impact the accounting treatment, and can obviously introduce the possibility that over the entire term of the contract, no actual risk will transfer. The coverage provided by the contract need not cease at the end of the term (e.g., the contract can cover occurrences as opposed to claims made or claims paid).

The contract should be considered to include any other agreements, written or oral, that confer rights, create obligations, or create benefits on the part of either or both parties. Ideally, the contract should contain an ‘Entire Agreement’ clause that assures there are no undisclosed written or oral side agreements that confer rights, create obligations, or create benefits on the part of either or both parties. If such rights, obligations or benefits exist, they must be factored into the tests of reasonableness and significance.

The contract should not contain arbitrary limitations on timing of payments. Provisions that assure both parties of time to properly present and consider claims are acceptable provided they are commercially reasonable and customary.

Provisions that expressly create actual or notional accounts that accrue actual or notional interest suggest that the contract contains, in fact, a deposit.

Provisions for additional or return premium do not, in and of themselves, render a contract something other than insurance. However, it should be unlikely that either a return or additional premium provision be triggered, and neither party should have discretion regarding the timing of such triggering.

All of the events that would give rise to claims under the contract cannot have materialized prior to the inception of the contract. If this "all events" test is not met, then the contract is considered to be a retroactive contract, for which the accounting treatment becomes complex.

International Accounting Principles
The relevant International Financial Reporting Standard (“IFRS”) for the accounting by an insurer or reinsurer is IFRS 4 “Insurance Contracts”, which was adopted in March of 2004 for financial reporting periods beginning on or after January 1, 2005. IFRS 4 is considered an interim, or Phase I, standard. Insurers and reinsurers are not required to adopt all aspects of this standard until such time as the permanent guidance is promulgated. Work is going on at this writing on Phase II of the standard.

IFRS 4 defines an insurance contract as a
 * “contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder .”

This definition differs from FAS, which explicitly requires indemnity. IAS refers to ‘compensating’ a policyholder and allows the possibility that the insured will receive a payment is more than would result from pure indemnity provided the Insured suffers a loss. However, IAS exempts from the definition of insurance all contracts that provide payments even if the specified uncertain future event has no adverse impact on the insured.

IFRS 4 requires that a contract be accounted for as insurance if the contract transfers significant insurance risk. “Insurance risk is significant if, and only if, an insured event could cause an insurer to pay significant additional benefits in any scenario, excluding scenarios that lack commercial substance .”

This test differs from FAS 113. Both standards agree that there needs to be a significant cost to the insurer possible under the contract. FAS 113 requires that there be a reasonable chance of such loss, while IFRS 4 only requires that at least one commercially reasonable scenario exists for such a loss. “If significant additional benefits would be payable in scenarios that have commercial substance, the condition [in the first sentence of the definition] may be met even if the insured event is extremely unlikely… ”

IFRS 4 specifically applies to insurers and reinsurers, and specifically excludes policyholder accounting other than that which would involve an insurance subsidiary, e.g., a captive. The ISAB states that it intends, at some future date, to address end user accounting treatment, but considers this to be low priority.

Constuction of an Insurance Policy
An insurance policy is a form of contract, generally in writing, that has clauses often grouped by categories. The cateogories "Declarations, Insuring Agreement, Conditions, and Exclusions can be recalled by the mnemonic acronym 'DICE.'

Declarations
Typically the Declarations section of an insurance contract consists of a page or two of information regarding the specifics of that particular contract. The Declaration page contains, for instance:
 * The premium;
 * The Limits of Liability;
 * The name and address of the insured;
 * The amount of any deductibles or self-insured retentions;
 * A schedule of endorsements to the policy; and often
 * A schedule of the items insured by the policy.

While the rest of the policy may be preprinted terms and conditions, a separate Declarations ordinarily is prepared for each insured.

Conditions
The conditions section of an insurance policy contain important operational components of the policy, including
 * Definitions;
 * Notice provisions;
 * Cancellation provisions;
 * Claims handling provisions;
 * Representations and Warranties;
 * Premium adjustment provisions; and
 * Other Insurance clauses.

United States and Canada
In the United States, regulation of the insurance industry is highly the responsibility of the several states, which place primary responsibility on state insurance departments. State insurance commissioners operate individually, though at times in concert through the National Association of Insurance Commissioners. In recent years, some have called for a dual state and federal regulatory system for insurance similar to that which oversees state banks and national banks.

In Canada ...

Underwriting
Underwriting is at its heart a process of discimination among risks that are presented to an insurer as candidates for insurance. The underwriter's job is to correctly classify a risk into the appropriate exposure group, and to set a premium approriate for that risk and group. In doing so, the underwriter must determine if the risk itself is acceptable to the insurer, if the risk is better or worse than the average on which the exposure group is based, what modifications to the customary insurance policy are needed to maintain the risk within acceptable bounds, and what price to pay.

Sound underwriting should be maintained for insurance companies to remain solvent. Thus, "discrimination" against (i.e., differential treatment of) potential insureds in the risk evaluation and premium-setting process is a necessary by-product of the fundamentals of insurance underwriting. Sound underwriting also means that the factors that form the basis of discrimination be meaningfully related to predicted loss expereince.

For instance, insurers charge older people significantly higher premiums than they charge younger people for term life insurance. Older people are thus treated differently than younger people (i.e., a distinction is made, discrimination occurs). The rationale for the differential treatment goes to the heart of the risk a life insurer takes: Old people are likely to die sooner than young people, so the risk of loss (the insured's death) is greater in any given period of time and therefore the risk premium must be higher to cover the greater risk. However, treating insureds differently when there is no actuarially sound reason for doing so is unlawful discrimination.

What is often missing from the debate is that prohibiting the use of legitimate, actuarially sound factors means that an insufficient amount is being charged for a given risk, and there is thus a deficit in the system. The failure to address the deficit may mean insolvency and hardship for all of a company's insureds. The options for addressing the deficit seem to be the following: Charge the deficit to the other policyholders or charge it to the government (i.e., externalize outside of the company to society at large).

Redlining and Other Forms of Illegal Discrimination
Redlining is term used to describe the practice of denying insurance coverage in specific geographic areas, purportedly because of a high likelihood of loss, when in fact the motivation is unlawful discrimination. Racial profiling or redlining has a long history in the property insurance industry in the United States. From a review of industry underwriting and marketing materials, court documents, and research by government agencies, industry and community groups, and academics, it is clear that race has long affected and continues to affect the policies and practices of the insurance industry.

In determining premiums and premium rate structures, insurers consider quantifiable factors, including location, credit scores, gender, occupation, marital status, and education level. However, the use of such factors is often considered to be unfair or unlawfully discriminatory, and the reaction against this practice has in some instances led to political disputes about the ways in which insurers determine premiums and regulatory intervention to limit the factors used.

An insurance underwriter evaluates the likelihood of a given risk producing an insured loss. In the absence of legal prohibitions to the contrary, factors that increase the likelihood of loss should be charged a higher rate. However, once a sufficiently large and robust group of homogenous expsoure units is created, that group should enjoy the same rate without regard to factors deemed illegal discimination. Redlining undermines this principle by adding additional underwriting factors that are contrary to statute.

Broker Impropriety
In the state of New York, former New York Attorney General Eliot Spitzer alleged that Marsh & McLennan steered business to insurance carriers based on the amount of contingent commissions that could be extracted from carriers, rather than basing decisions on whether carriers had the best deals for clients. Several of the largest commercial insurance brokerages have since stopped accepting contingent commissions and have adopted new business models.