Introduction
Prof. William R. Long 1/16/05
The Goals of Insurance
The purpose of these notes is twofold: (1) to provide a guide to my introductory Insurance Law class at Willamette University College of Law and (2) to present a series of principles, illustrated through cases, that will help the general reader understand the basis of insurance law. Insurance is so pervasive in our society, and insurance policies are generally perceived to be difficult to read and confusing, that an introduction to principles, cases and insurance policies will allow one to live more confidently in a world where insurance companies and carriers play an increasingly greater role.
This page introduces the concepts of risk, adverse selection, moral hazard, indemnification and some philosophical questions that lie behind the practice of insurance.
Introductory Concepts and Issues
One of the regrettable realities of life is that it is full of risks. Danger is all around us. Hazards threaten. Possibilities of loss or injury greet us everywhere we go. And we all respond somewhat differently to the reality of risk that faces us. For example, in the face of risk, some of us overcompensate. Some of us, as it were, dress in knee pads and helmets as we live our lives. We not only take reasonable precautions but we sometimes curtail some of the joy of living because we are so risk averse. Others of us fly to the other extreme and seemingly deny or ignore the risk that faces us. We live large and, in the words of the Wizard of Oz, we "laugh in the face of death, sneer at doom and chuckle at catastrophe." Most of us, however, seek to take steps to minimize the risks that life presents without abandoning a normal life.
The basic goal of insurance is to address the potential economic loss that risk presents. Be sure that you highlight the word "economic" in the previous sentence. Insurance does not try to handle the emotional traumas attendant upon life--such as when your boyfriend/girlfriend breaks up with you--but is primarily concerned with compensating you or your designated beneficiaries in case your property, health or life is hurt or lost. This process of compensation is called indemnification. To indeminify someone means to compensate them for a covered loss. That is what insurance fundamentally does.
How does insurance "address" this economic loss or the potential of such loss? By allowing risk to be transferred from the ones who might suffer loss to others. The concept of "risk transfer," therefore, is key to understanding what insurance is about. I face risk. I don't want to live with it. I wish others would take it on for me. Insurance policies are meant to do that.
They do so through the concept of "risk pooling." You are not the only person who would like to get rid of the economic risk of loss in your life. Other rational actors do too. In fact, most people do. Insurers try to put people into homogeneous groups and thus minimize the hazard to them as well as enable them to be indemnified when loss occurs. They do so because they have access to information that tells them that in a typical year people who fit your profile tend to have XX number of accidents or suffer XX amount of loss to their vehicle, property or health. When they combine a large enough pool together, they can pretty well estimate how many people of a pool of a certain size are going to suffer what kind of losses within a year. This "risk pooling" thus allows them to "allocate the risk" by charging you a premium. This premium, which differs based on hazards presented, deductible, and a host of other factors, allows you to go about your life with minimum interruption and maximum assurance that your goods (or their economic equivalent) are secure. It also allows insurance companies to make a profit (because they can charge slightly more than enough to compensate projected losses).
These three concepts, "risk transfer," "risk pooling," and "risk allocation" (which is sometimes called "risk distribution") are at the heart of what insurance wants to do.
Dangers to Insurers
You may be inclined to think that the insurers are the "bad guys" who can charge whatever they want, hold back on payouts and generally make life miserable for their insureds. More than one company has indeed done that. But there are some hazards to insurers that they need to protect themselves against that should be noted.
First, they need to protect themselves against adverse selection. Adverse selection is the principle suggesting that those most in need of insurance will want most coverage for the lowest rates. Adverse selection tells us that those most in need of insurance, because of poor health or ill-protected goods or highly dangerous activities, will be tempted to minimize or even misrepresent their true situations to insurers so that they can get coverage. Insurers are alert to this, and usually handle this danger by requring pre-issuance examinations, certifications that everything you represented on an application is correct, or questionnaires. Sometimes there is a waiting period until an policy goes into effect or limitations on coverage of pre-existing conditions.
Second, insurers need to avoid moral hazard. Moral hazard is especially evident in insuring property and refers to the danger that too much insurance on a property will give a person an incentive to destroy the subject matter and collect the insurance proceeds to make money. Thus an insurer needs to be aware of the value of a property and only permit policies to cover, at the most, replacement value of goods and structures.
Closing with some Philosophy
Insurance companies grew up in the 18th century to indemnify people and businesses and enable them to continue on in business or life without the worries that massive loss will end your productive life. But one question that arises is the extent to which the insurer and insured should be regulated. Is this the kind of relationship where governmental regulation is required? If so, what kinds of requirements? Should policies be examined by a neutral third party or should the "buyer beware?" Should government only assure that the insurers have sufficient assets to cover projected losses? Or should government have nothing to do with the "business" of insurance apart from requiring insurance businesses to register with the secretary of state?
And, if you are in favor of regulation of insurers (just to give you a clue, all 50 states regulate insurers), should it be primarily at the state or federal level? Historically regulation has been at the state level, because most insurers were local entities, but now, with the global reach of insurance conglomerates, state regulators are arguing that there may be a federal role to play in standardization of policies.
We will touch on some of these issues as the semester progresses, but our primary concern will be to unfold and understand basic insurance doctrine.
Copyright © 2004-2007 William R. Long |