Insurance, a system under which the insurer, for a consideration usually agreed upon in advance, promises to reimburse the insured or to render services to the insured in the event that certain accidental occurrences result in losses during a given period. It thus is a method of coping with risk. Its primary function is to substitute certainty for uncertainty as regards the economic cost of loss-producing events.
Insurance relies heavily on the “law of large numbers.” In large homogeneous populations it is possible to estimate the normal frequency of common events such as deaths and accidents. Losses can be predicted with reasonable accuracy, and this accuracy increases as the size of the group expands. From a theoretical standpoint, it is possible to eliminate all pure risk if an infinitely large group is selected.
From the standpoint of the insurer, an insurable risk must meet the following requirements:
1. The objects to be insured must be numerous enough and homogeneous enough to allow a reasonably close calculation of the probable frequency and severity of losses.
2. The insured objects must not be subject to simultaneous destruction. For example, if all the buildings insured by one insurer are in an area subject to flood, and a flood occurs, the loss to the insurance underwriter may be catastrophic.
3. The possible loss must be accidental in nature, and beyond the control of the insured. If the insured could cause the loss, the element of randomness and predictability would be destroyed.
4. There must be some way to determine whether a loss has occurred and how great that loss is. This is why insurance contracts specify very definitely what events must take place, what constitutes loss, and how it is to be measured.
From the viewpoint of the insured person, an insurable risk is one for which the probability of loss is not so high as to require excessive premiums. What is “excessive” depends on individual circumstances, including the insured’s attitude toward risk. At the same time, the potential loss must be severe enough to cause financial hardship if it is not insured against. Insurable risks include losses to property resulting from fire, explosion, windstorm, etc.; losses of life or health; and the legal liability arising out of use of automobiles, occupancy of buildings, employment, or manufacture. Uninsurable risks include losses resulting from price changes and competitive conditions in the market. Political risks such as war or currency debasement are usually not insurable by private parties but may be insurable by governmental institutions. Very often contracts can be drawn in such a way that an “uninsurable risk” can be turned into an “insurable” one through restrictions on losses, redefinitions of perils, or other methods.
Kinds of insurance
Two main types of contracts—homeowner’s and commercial—have been developed to insure against loss from accidental destruction of property. These contracts (or forms) typically are divided into three or four parts: insuring agreements, identification of covered property, conditions and stipulations, and exclusions.
Homeowner’s insurance covers individual, or nonbusiness, property. Introduced in 1958, it gradually replaced the older method of insuring individual property under the “standard fire policy.”
In homeowner’s policies, of which there are several types, coverage can be “all risk” or “named peril.” All-risk policies offer insurance on any peril except those later excluded in the policy. The advantage of these contracts is that if property is destroyed by a peril not specifically excluded the insurance is good. In named-peril policies, no coverage is provided unless the property is damaged by a peril specifically listed in the contract.
In addition to protection against the loss from destruction of an owner’s property by perils such as fire, lightning, theft, explosion, and windstorm, homeowner’s policies typically insure against other types of risks faced by a homeowner such as legal liability to others for injuries, medical payments to others, and additional expenses incurred when the insured owner is required to vacate the premises after an insured peril occurs. Thus the homeowner’s policy is multi-peril in nature, covering a wide variety of risks formerly written under separate contracts.
Homeowner’s forms are written to cover damage to or loss of not only an owner’s dwelling but also structures (such as garages and fences), trees and shrubs, personal property (excluding certain listed items), property away from the premises (such as boats), money and securities (subject to dollar limits), and losses due to forgery. They also cover removal of debris following a loss, expenditures to protect property from further loss, and loss of property removed from the premises for safety once an insured peril has occurred.
Limitations on amount recoverable
Recovery under homeowner’s forms is limited to loss due directly to the occurrence of an insured peril. Losses caused by some intervening source not insured by the policy are not covered. For example, if a flood or a landslide, which usually are excluded perils, severely damages a house that subsequently is destroyed by fire, the homeowner’s recovery from the fire is limited to the value of the house already damaged by the flood or landslide.
Recovery under homeowner’s forms may be on the basis of either full replacement cost or actual cash value (ACV). Under the former, the owner suffers no reduction in loss recovery due to depreciation of the property from its original value. This basis applies if the owner took out coverage that is at least equal to a named percentage—for example, 80 percent—of the replacement value of the property.
If the insurance amount is less than 80 percent, a coinsurance clause is triggered, the operation of which reduces the recovery amount to the value of the loss times the ratio of the amount of insurance actually carried to the amount equal to 80 percent of the value of the property. However, the reduced recovery will not be less than the “actual cash value” of the property, defined as the full replacement cost minus an allowance for depreciation, up to the amount of the policy. For example, assume that a property is valued at $100,000 new, has depreciated 20 percent in value, insurance of $60,000 is taken, and a $10,000 loss occurs. The actual cash value of the loss is $8,000 ($10,000 minus 20 percent depreciation). The operation of the coinsurance clause would limit recovery to 6/8 of the loss, or $7,500. However, since the actual cash value of the loss is $8,000, this is the amount of the recovery.
Recovery under homeowner’s forms is also limited if more than one policy applies to the loss. For example, if two policies with equal limits are taken out, each contributes one-half of any insured loss. Loss payments also are limited to the amount of an insured person’s insurable interest. Thus, if a homeowner has only a one-half interest in a building, the recovery is limited to one-half of the insured loss. The co-owners would need to have arranged insurance for their interest.
Among the excluded perils (or exclusions) of homeowner’s policies are the following: loss due to freezing when the dwelling is vacant or unoccupied, unless stated precautions are taken; loss from weight of ice or snow to property such as fences, swimming pools, docks, or retaining walls; theft loss when the building is under construction; vandalism loss when the dwelling is vacant beyond 30 days; damage from gradual water leakage; termite damage; loss from rust, mold, dry rot, contamination, smog, and settling and cracking; loss from animals or insects; loss from earth movement, flood, war, or spoilage (e.g., chemical deterioration); loss from neglect of the insured to protect the property following a loss; and losses arising out of business pursuits. Special forms for business risks are available (see below).
Under named-peril forms, only losses from the perils named in the policy are covered. The named perils are sometimes defined narrowly; for example, theft claims are not paid if the property is merely lost and theft cannot be established.
Earthquake and flood loss, while excluded from the basic homeowner’s forms, may usually be covered by endorsement.
Homeowner’s policies may include the following conditions: (1) Owners are required to give immediate written notice of loss to the insurer or the insurer’s agent. (2) The insured must provide proof of the amount of loss. This suggests that owners should keep accurate records of the items in a building and of their original cost. (3) The insured must cooperate with the insurer in settling a loss. (4) The insured must pay the premium in advance. (5) The insurer has a right of subrogation (i.e., of pursuing liable third parties for any loss). This prevents an owner from collecting twice, once from the insurer and once from a liable third party. (6) A mortgagee’s interest in a property can be protected. (7) The policy may be canceled by the insurer upon due notice, usually 10 days. If the insurer cancels, a pro rata refund of premium must be returned to the insured; if the insured cancels, a less-than-proportionate return of a premium may be recovered from the insurer. (8) Fraud by the insured, including misrepresentation or concealment of material facts concerning the risk, is ground for denial of benefits by the insurer.
Also available is a form called renter’s insurance, which provides personal property insurance for tenants.
Business property insurance
Insurance for business property follows a pattern that is similar in many ways to the one for individual property. A commonly used form is the “building and personal property coverage form” (BPP). This form permits a business owner to cover in one policy the buildings, fixtures, machinery and equipment, and personal property used in business and the personal property of others for which the business owner is responsible. Coverage also can be extended to insure newly acquired property, property on newly acquired premises, valuable papers and records, property temporarily off the business premises, and outdoor property such as fences, signs, and antennas.
Coverage on the BPP form can be written on a scheduled basis, whereby specific items of property are listed and insured, or on a blanket basis, whereby property at several locations can be insured for a single sum.
Perils insured under the BPP are listed in the policy. All-risk coverage is also written, subject to specified exclusions.
Losses may be settled on a replacement-cost coverage on the BPP by endorsement. Otherwise recovery is on an actual cash value basis that makes an adjustment for depreciation.
Coverage for business personal property with constantly changing values is available on a reporting form. The business owner reports values monthly to the insurer and pays premiums based on the values reported. In this way, only the insurance actually needed is purchased.
An entirely different branch of the insurance business has been developed to insure losses that are indirectly the result of one of the specified perils. A prominent example of this type of insurance is business income insurance. The insurer undertakes to reimburse the insured for lost profits or for fixed charges incurred as a result of direct damage. For example, a retail store might have a fire and be completely shut down for one month and partially shut down for another month. If the fire had not occurred, sales would have been much higher, and therefore substantial revenues have been lost. In addition, fixed costs such as salaries, taxes, and maintenance must continue to be paid. A business income policy would respond to these losses.
Forms of indirect insurance include the following: (1) contingent business income insurance, designed to cover the consequential losses if the plant of a supplier or a major customer is destroyed, resulting in either reduced orders or reduced deliveries that force a shutdown of the insured firm, (2) extra expense insurance, which pays the additional cost occasioned by having extra expenses to pay, such as rent on substitute facilities after a disaster, and (3) rent and rental value insurance, covering losses in rents that the owner of an apartment house may incur if the building is destroyed. Rental income insurance pays for rent lost when a peril destroys an owner’s property that has been rented to others.
Marine insurance is actually transportation insurance. After insurance coverage on ocean voyages had been developed, it was a natural step to offer insurance on inland trips. This branch of insurance became known as inland marine. In many policy forms, the distinction between inland and ocean marine has disappeared; it is common to cover goods from the time they leave the warehouse of the shipper, even if this warehouse is situated at a substantial distance from the nearest seaport, until they reach the warehouse of the buyer, which likewise may be located far inland.
Ocean marine insurance
Ocean marine contracts are written to cover four major types of property interest: (1) the vessel or hull, (2) the cargo, (3) the freight revenue to be received by the ship owner, and (4) legal liability for negligence of the shipper or the carrier. Hull insurance covers losses to the vessel itself from specified perils. Usually there is a provision that the marine hull should be covered only within specified geographic limits. Cargo insurance is usually written on an open contract basis under which shipments, both incoming and outgoing, are automatically covered for the interests of the shipper, who reports periodically the values exposed and pays a premium based upon these values. By means of a negotiable open cargo certificate, which is attached to the bill of lading, insurance coverage is automatically transferred to whoever has legal title to the goods in the course of their movement from seller to buyer.
Freight revenue may be insured in several different ways. If there is an obligation by the shipper to pay the carrier’s freight bill regardless of whether the goods are delivered, the value of the freight is declared a part of the value of the cargo and is insured as part of this value. If the freight revenue is contingent upon safe delivery of the goods, the carrier insures the freight as a part of the regular hull coverage.
Major clauses or provisions that are fairly standardized are (1) the perils clause, (2) the “running down” clause, or RDC, (3) the “free of particular average,” or FPA, clause, (4) the general average clause, (5) the sue and labour clause, (6) the abandonment clause, (7) coinsurance, and (8) express and implied warranties. Each of these will be discussed in turn.
Until 1978 the main insuring clause of modern ocean marine policies was preserved almost unchanged from the original 1779 Lloyd’s of London form. The clause is as follows:
Touching the adventures and perils which we the assurers are contented to bear and do take upon us in this voyage: they are of the seas, men-of-war, fire, enemies, pirates, rovers, thieves, jettisons, letters of mart and countermart, surprisals, takings at sea, arrests, restraints, and detainments of all kings, princes, and people, of what nation, condition, or quality soever, barratry of the master and mariners, and of all other perils, losses, and misfortunes, that have or shall come to the hurt, detriment, or damage of the said goods and merchandises, and ship, etc., or any part thereof.
Although the clause reads as if it were an all-risk agreement, courts have interpreted it to cover only the perils mentioned. Essentially, the clause insures the voyage from perils “of” the sea. Perils on the sea, such as fire, are not covered unless specifically mentioned. Furthermore, although the perils clause indicates coverage from “enemies, pirates, rovers, thieves,” the policy does not cover losses from war. (War risk insurance is offered in some nations through governmental agencies.)
In 1978, at the request of the UN Conference on Trade and Development, the 1779 language was modernized and a revised insuring clause was proposed. The new form restricts coverage on losses from poor packing, places the burden of proof of seaworthiness on the shipper rather than on the carrier, and excludes losses resulting from insolvency of the common carrier, with the burden of proof placed on the shipper that the carrier is financially sound. The revised form has not been adopted by all insurers.
The RDC, or “running down” clause, provides coverage for legal liability of either the shipper or the common carrier for claims arising out of collisions. (Collision loss to the vessel itself is part of the hull coverage.) The RDC clause covers negligence of the carrier or shipper that results in damage to the property of others. A companion clause, the protection and indemnity clause (P and I), covers the carrier or shipper for negligence that causes bodily injury to others.
The FPA, or “free of particular average,” clause excludes from coverage partial losses to the cargo or to the hull except those resulting from stranding, sinking, burning, or collision. Under its provisions, losses below a given percentage of value, say 10 percent, are excluded. In this way the insurer does not pay for relatively small losses to cargo. The percentage deductible varies according to the type of cargo and its susceptibility to loss.
General average clause
The general average clause in ocean marine insurance obligates the insurers of various interests to share the cost of losses incurred voluntarily to save the voyage from complete destruction. Such sacrifices must be made voluntarily, must be necessary, and must be successful. For example, if a shipper’s cargo is voluntarily jettisoned in a storm in order to save the vessel from total loss, the general average clause requires the insurers of the hull and of all other cargo interests to make a contribution to the loss of the shipper whose goods were sacrificed. Other types of losses may also be covered. It has been held, for example, that losses suffered from efforts to put out a fire on shipboard, which result in damage to specific goods, can be included in a general average claim. Similarly, losses from salvage efforts to free a stranded vessel may qualify under a general average claim to which all interests must contribute.
Sue and labour clause
The sue and labour clause requires the ship owner to make every attempt to reduce or save the exposed interests from loss. Under the terms of the clause, the insurer pays for any necessary costs incurred in carrying out the requirements of the sue and labour clause. Thus, if a ship is stranded, under the sue and labour clause the hull owner would be required to hire salvors to attempt to save the ship. Such expenses are paid even if the salvage attempts fail.
If salvaging or rehabilitating a ship or cargo following a marine loss costs more than the goods are worth, the loss is said to be constructively total. Under such conditions, the ocean marine policy permits the insured to abandon the damaged ship or cargo to the insurer and make a claim for the entire value. In this case, the salvage belongs to the insurer, who may dispose of it in any way. Abandonment is not permitted in other forms of property insurance.
Although there is no coinsurance clause as such in the ocean marine policy, losses are settled as though a 100 percent coinsurance clause existed. Thus, if an insured takes out coverage equal to 50 percent of the true replacement cost of the goods, only 50 percent of any partial loss may be recovered.
In the field of ocean marine insurance there are two general types of warranties that must be considered: express and implied. Express warranties are promises written into the contract. There are also three implied warranties, which do not appear in written form but bind the parties nevertheless.
Examples of expressed warranties are the FC&S warranty and the strike, riot, and civil commotion warranty. The FC&S, or “free of capture and seizure,” warranty excludes war as a cause of loss. The strike, riot, and civil commotion warranty states that the insurer will pay no losses resulting from strikes, walkouts, riots, or other labour disturbances. The three implied warranties relate to the following conditions: seaworthiness, deviation, and legality. Under the first, the shipper and the common carrier warrant that the ship will be seaworthy when it leaves port, in the sense that the hull will be sound, the captain and crew will be qualified, and supplies and other necessary equipment for the voyage will be on hand. Any losses stemming from lack of seaworthiness will be excluded from coverage. Under the deviation warranty, the ship may not deviate from its intended course except to save lives. Clauses may be attached to the ocean marine policy to eliminate the implied warranties of seaworthiness or deviation. The implied warranty of legality, however, may not be waived. Under this warranty, if the voyage itself is illegal under the laws of the country under whose flag the ship sails, the insurance is void.
Inland marine insurance
Although there are no standard forms in inland marine insurance, most contracts follow a typical pattern. They are usually written on a named-peril basis covering such perils of transportation as collision, derailment, rising water, tornado, fire, lightning, and windstorm. The policies generally exclude losses resulting from pilferage, strike, riot, civil commotion, war, delay of shipments, loss of markets, illegal trade, or leakage and breakage.
The scope of inland marine is greatly extended by means of “floater” policies. These are used to insure certain types of movable property whether or not the property is actually in transit. Business floater policies are purchased by jewelers, launderers, dry cleaners, tailors, upholsterers, and other persons who hold the property of others while performing services. Personal property floaters are used to cover, on a comprehensive basis, any item of personal property owned by a private individual. They may also cover the property of visitors, or the property of servants while on the premises of the insured. They exclude certain types of property for which other contracts have been designed, such as automobiles, aircraft, motorcycles, animals, or business and professional equipment.
Liability insurance arises mainly from the operation of the law of negligence. Individuals who, in the eyes of the law, fail to act reasonably or to exercise due care may find themselves subject to large liability claims. Court judgments have been issued for sums so large as to require a lifetime to pay.
There are at least four major types of liability insurance contracts: (1) liability arising out of the use of automobiles, (2) liability arising out of the conduct of a business, (3) liability arising from professional negligence (applicable to doctors, lawyers, etc.), and (4) personal liability, including the liability of a private individual operating a home, carrying on sporting activities, and so on.
Practically all liability contracts falling in these four categories have some common elements. One is the insuring clause, in which the insurer agrees to pay on behalf of the insured all sums that the insured shall become legally obligated to pay as damages because of bodily injury, sickness or disease, wrongful death, or injury to another person’s property. The liability policy covers only claims that an insured becomes legally obligated to pay; voluntary payments are not covered. It is often necessary to resort to legal or court action to determine the amount of these damages, although in a vast majority of cases the damages are settled out of court by negotiation between the parties.
All liability insurance contracts contain clauses that obligate the insurer to conduct a court defense and to pay any settlement, including premiums on bonds, interest on judgments pending appeal, medical and surgical expenses that are necessary at the time of the accident, and other costs. Liability insurance has sometimes been termed defense insurance because of this provision. The insurer agrees to defend a suit even though it is false or fraudulent, so long as it is a suit stemming from a peril insured against. The insured is required to cooperate with the insurer in all court actions by appearing in court, if necessary, to give testimony.
Limits of liability
Practically all liability insurance policies contain limitations on the maximum amount of a judgment payable under the contract. Further, the cost of defense, supplementary payments, and punitive damages may or may not be paid in addition to the judgment limits. Separate limits often apply to claims for property damage and bodily injury. An annual aggregate limit may also be purchased, which puts a maximum on the amount an insurer must pay in any one policy period.
Limits may apply on a per-occurrence or a claims-made basis. In the former, which gives the most comprehensive coverage, the policy in force in year one covers a negligent act that took place in year one, no matter when a claim is made. If the policy is made on a claims-made basis, the insurance in force when a claim is presented pays the loss. Under this policy, a claim can be made for losses that occur during the policy period but have their origins in events preceding its starting date; the period of time before this date for which claims can be made is, however, restricted. For an additional premium the discovery period can be extended beyond the end of the policy period. The claims-made basis for liability insurance is considered much more restrictive than a per-occurrence policy.
Liability insurance contracts have in common the fact that the definition of “the insured” is broad. An automobile liability policy, for example, includes not only the owner but anyone else operating the car with permission. In business liability insurance, all partners, officers, directors, or proprietors are covered by the policy regardless of their direct responsibility for any act of negligence. Other parties may be included for an extra premium.
Another element common to all liability insurance policies is certain exclusions. Policies covering business activities almost invariably exclude liability arising out of the personal activities of the insured. Each kind of liability contract tends to exclude the liability for which another contract has been devised: a personal liability coverage in the homeowner’s contract, for example, excludes automobile liability because a special contract has been created for this particular type of liability.
Another common element in liability policies is subrogation: the insurer retains the right to bring an action against a liable third party for any loss this third party has caused.
Business liability insurance
Business liability contracts commonly written include the following: liability of a building owner, landlord, or tenant; liability of an employer for acts of negligence involving employees; liability of contractors or manufacturers; liability to members of the public resulting from faulty products or services; liability as a result of contractual agreements under which liability of others is assumed; and comprehensive liability. The latter contract is designed to be broad enough to encompass almost any type of business liability, including automobiles. There has been increasing use of coverage for liability stemming from defective products, because some court judgments have awarded huge compensations.
Business liability contracts may be written to cover loss even if the act that produced the claim was not accidental. The only requirement is that the result of the act be accidental or unintended. Thus if a contractor is making an excavation that produces large amounts of dust and this dust causes loss to neighbouring property, the contractor’s liability policy would respond to claims for loss, even though the act that produced the dust was a deliberate act.
Professional liability insurance
Known as malpractice, or errors-and-omissions, insurance, professional liability contracts are distinguished from general business liability policies because of the specialized nature of the liability. Professional persons requiring liability contracts include physicians and surgeons, lawyers, accountants, engineers, and insurance agents. Important differences between professional and other liability contracts are the following:
1. No distinction is made between bodily injury or property damage liability, and there is no limit on the number of claims per accident but rather a limit of liability per claim. This recognizes the fact that one negligent act on the part of a professional person may involve more than one party, each of whom could bring a legal action against the professional person. Thus a doctor might administer the wrong medicine to a number of patients, each of whom could bring a legal action.
2. Claims against a professional person may have an adverse effect upon his or her reputation. The policy therefore permits the insured to carry any action to court, since an out-of-court settlement might conceivably imply guilt in the eyes of the professional’s public or clientele.
3. In professional liability insurance there is an exclusion for any agreement guaranteeing the result of any treatment. Suits stemming from clients’ dissatisfaction with the service performed are thus not covered.
Personal liability insurance
The most common form of personal liability insurance is issued as part of the homeowner’s liability insurance policy. It is an all-risk agreement and contains relatively few exclusions. The policy covers any act of negligence of the insured or residents of the home that results in legal liability. It may also include medical payments insurance covering accidental injury to guests and other nonresidents without regard to the question of negligence.
Nearly half of all property-liability insurance written in the United States is in the area of automobile insurance. Set up as a comprehensive contract in most parts of the world, automobile insurance covers liability, collision loss of the vehicle, all other types of loss (called comprehensive loss), and medical expenses incurred by the driver, passengers, and other persons. Coverage usually applies to anyone driving the car with permission of the owner. Thus, drivers are insured whether driving their own or someone else’s car.
Automobile liability coverage is mandated by law in many countries up to specified monetary limits. The policy states what happens if the driver is covered by other automobile policies that may cover the loss. It also covers the liability of persons, such as parents, who have legal responsibility for actions of the driver. Coverage includes legal defense costs, usually in addition to the policy liability limits. Many policies exclude coverage for the time the automobile is driven in a foreign country.
Theft generally covers all acts of stealing. There are three major types of insurance contracts for burglary, robbery, and other theft. Burglary is defined to mean the unlawful taking of property within premises that have been closed and in which there are visible marks evidencing forcible entry. Such narrow definition is necessary to restrict burglary coverage to a particular class of criminal act. Robbery is defined as that type of unlawful taking of property in which another person is threatened by either force or violence. In the robbery peril, therefore, the element of personal contact is necessary.
Perhaps the most common of all burglary coverages is on safes. Often the loss in the form of damage to the safe itself from the use of explosives and other devices is as great as the loss of the money, jewelry, or securities it contains. Accordingly, the policy covers both types of claims. Another common burglary policy applies to mercantile open stock. In this type of policy, there is usually a limit applicable on any article of jewelry or any article contained in a showcase where susceptibility to loss is high. In order to prevent underinsurance, the mercantile open stock policy is usually written with a coinsurance requirement or with some minimum amount of coverage.
Another common theft policy for business firms is a comprehensive crime contract covering employee dishonesty as well as losses on money and securities both inside and outside the premises, loss from counterfeit money or money orders, and loss from forgery. This policy is designed to cover in one package most of the crime perils to which an average business is subject.
A broad form of crime protection for individuals is offered both as a separate contract and as part of a “homeowner’s policy.” It covers all losses of personal property from theft and mysterious disappearance.
Aviation insurance normally covers physical damage to the aircraft and legal liability arising out of its ownership and operation. Specific policies are also available to cover the legal liability of airport owners arising out of the operation of hangars or from the sale of various aviation products. These latter policies are similar to other types of liability contracts.
Perhaps the major underwriting problem is the “catastrophic” exposure to loss. The largest passenger aircraft may incur losses of $300,000,000 or more, counting both liability and physical damage exposures. The number of aircraft of any particular type is not large enough for the accurate prediction of losses, and each type of aircraft has its special characteristics and equipment. Thus a great deal of independent individual underwriting is necessary. Rate making is complex and specialized. It is further complicated by rapid technological change and by the constant appearance of new hazards.
Policies are written to cover liability of the owner or operator for bodily injury to passengers or to persons other than passengers and for property damage. Medical costs, including loss of income, are usually paid to passengers suffering permanent total disability without the requirement of proving negligence. This type of coverage has been called admitted liability insurance.
Workers’ compensation insurance
Workers’ compensation insurance, sometimes called industrial injury insurance, compensates workers for losses suffered as a result of work-related injuries. Payments are made regardless of negligence. The schedule of benefits making up the compensation is determined by statute.
The scope of employment injury laws, originally limited to persons in forms of employment recognized as hazardous, has, as the result of associating the right to compensation with the existence of a contract of service, been gradually extended to clerical employment. Nevertheless, the large exception of agricultural employees continues in some developing countries, Canada, much of the United States, and the countries of eastern Europe. Other classes of exception are employees in very small undertakings and domestic servants. The exclusion of employees with middle-class salaries persists in parts of the former British Empire. In a few countries, working employers are permitted to insure themselves as well as their employees.
The notion of employment injury was at first confined to injuries of accidental origin, but during the 20th century it was extended to include occupational diseases in increasing number. To entitle the worker to benefit, the accident must occur during employment, and many laws also require the accident to have been caused by the employment in some way; however, the trend seems to be toward accepting the former condition as sufficient. Following the German law of 1925, some 30 countries included accidents occurring on the way to and from work. Injuries due to the employee’s willful misconduct are generally excluded. Occupational diseases are covered to some extent by virtually all national laws.
Classes of benefits
Four classes of benefits are provided by compulsory insurance, and, except for certain diseases, a right to them is acquired without any qualifying period of previous employment. First is a medical benefit, which includes all necessary treatment and the supply of artificial limbs. If its duration is limited, the maximum is likely to be one year. Second is a temporary incapacity benefit, which lasts as long as the medical benefit except that a waiting period of a few days is frequently prescribed. The benefit varies from country to country, ranging from 50 percent of the employee’s wage to 100 percent; the most common benefits are 66 2/3 percent and 75 percent. Third is a permanent incapacity benefit, which, unless the degree is very small, in which case a lump sum is paid, takes the form of a pension. If the incapacity is total, the pension is usually equal to the temporary incapacity benefit. If the incapacity is partial, the pension is proportionately smaller. In some 60 countries an additional pension is granted if the victim needs constant attendance. In cases of death, the pensions are distributed to the widow (or invalid widower) and minor children, and, if the maximum total has not then been attained, other dependents may receive small pensions. The maximum is the same as for total incapacity.
In a growing number of industrialized countries (Austria, France, Germany, Ireland, Israel, the Netherlands, and Switzerland) the fourth type of benefit—systematic arrangements for retraining and rehabilitation of seriously injured persons—is provided, and employers may even be required to provide employment to such persons.
Financing and administering employment injury insurance
Almost all systems of employment injury insurance are financed by employers’ contributions exclusively, and in almost all these systems the contribution is proportional to the risk represented by the class of activity in which the employer is engaged. Usually the insurance institution adapts the contribution to the accident experience of the undertaking individually or to any special preventive measures it may have taken. On the other hand, mainly for simplicity, but partly perhaps in order to subsidize basic but dangerous industries, a uniform contribution rate for all classes of activity has been established in several countries.
Social insurance against employment injury, as against other risks, is in most countries administered by institutions under the joint management of employers and employees and often of government representatives as well; in eastern Europe, however, the administration is entrusted to trade unions. Disputes are settled by arbitral organs without resort to the courts.
In the United States an employer may comply with the provisions of most workers’ compensation laws in three ways: by purchasing a private workers’ compensation and employer liability policy from a commercial insurer, by purchasing coverage through a state fund set up for this purpose, or by setting aside reserves sufficient to cover the risks involved. Most workers’ compensation benefits are financed by the first two methods.
State laws in the United States are not uniform with respect to the amount of the monetary compensation or length of time for which income payments are made. For example, only about half the states give lifetime income benefits for occupational injuries. In others there is a statutory limitation of between 400 and 500 weeks of payments. Again, most states provide liquidating damages for an injury that is permanent but does not totally incapacitate the worker, such as the loss of an arm or leg. The size of these liquidating damages varies greatly. Most state laws also provide complete medical benefits, including rehabilitation expenses, and survivors’ benefits in the event of the worker’s death.
Following the publication in the early 1970s of about 40 studies revealing inadequacies in workers’ compensation in the United States, most states passed laws increasing the number of workers covered, raising weekly benefits to equal or exceed 66 2/3 percent of the average weekly wage, and making other improvements. Compensable claims now include those involving back pain, stress, and heart conditions traceable to employment conditions. Many claims also involve court litigation, which greatly magnifies settlement costs. For employers, these and other factors have increased the average cost of benefits from less than 1 percent of wages before 1960 to 2.3 percent in 1992.
The use of credit in modern societies is so various and widespread that many types of insurance have grown up to cover some of the risks involved. Examples of these risks are the risk of bad debts from insolvency, death, and disability; the risk of loss of savings from bank failure; the risk attaching to home-loan debts when installments are not paid for various reasons, resulting in foreclosure with subsequent loss to the creditor; and the risk of loss from export credit because of war, currency restrictions, cancellation of import licenses, or other political causes.
Merchandise credit insurance
Credit insurance for domestic buyers and sellers is available in the United States, Canada, Mexico, and most European countries. It is sold only to manufacturers, wholesalers, and certain service agencies, not to retailers. The insurance is designed to enable the seller to recover a certain percentage of losses from insolvency of the debtor, but the contracts list a number of conditions under which the creditor may initiate a claim regardless of the question of insolvency. The policy is designed primarily to meet the needs of those sellers whose business is concentrated on a few buyers, insolvency of any one of which would seriously jeopardize the financial stability of the seller.
Export credit insurance
A special form of credit insurance is available to exporters against losses from both commercial and political risks. In the United States, for example, export credit insurance is written through a consortium of insurance companies organized by the Foreign Credit Insurance Association (FCIA). The Export-Import Bank of the United States assumes the ultimate liability for loss, while the FCIA serves as the underwriting agency. Coverage is usually limited to 90 or 95 percent of the account. Prior approval from the FCIA is usually required before export credit insurance is granted. In some cases, the exporter is required to purchase coverage on all credit sales in a given country as a device to reduce adverse selection.
Export credit insurance is used more widely in some countries than in others. In the United Kingdom approximately one-quarter of all export sales are covered, compared with about 6 percent in the United States. Export sales are not eligible for insurance if they are made for cash or financed directly or indirectly through government-guaranteed loans.
Title insurance is a contract guaranteeing the purchaser of real estate against loss from undiscovered defects in the title to property that has been purchased. Such loss may stem from unmarketability of the property because of defective title or from costs incurred to cure defects of the title.
The need for title insurance arises from the fact that real estate transactions are complex and technical. Any legal error, no matter how detailed or minute, may cause a defect in the title that impairs its marketability. Examples of such defects are forgeries, invalid or undiscovered wills, defective probate proceedings, or transfers of property by persons lacking full legal capacity to contract.
Special casualty forms are issued to cover the hazards of sudden explosions from equipment such as steam boilers, compressors, electric motors, flywheels, air tanks, furnaces, and engines. Boiler and machinery insurance has several distinctive features. A substantial portion of the premium collected is used for inspection services rather than loss protection. Second, the boiler policy provides that its coverage will be in excess of any other applicable insurance. In this sense, it may be looked upon as an “umbrella policy” to fill in gaps in the insured’s program. Third, the policy lists the specific losses that will be paid, such as the loss of the boiler or machinery itself due to accident, expediting expenses, property damage liability, bodily injury liability, defense settlement and supplementary payments, business interruption, outage (interruption of service), power interruption, consequential loss due to spoilage of goods, and furnace explosion. The policy will satisfy each of these claims in the order in which they appear, up to the limit of the coverage.
The extensive use of plate glass in modern architecture has produced a special comprehensive insurance that covers not only plate glass but glass signs, motion-picture screens, halftone screens and lenses, glass bricks, glass doors, and so forth. It may be written to cover loss from any source except fire or nuclear radiation.
Increasing international business activity has caused greater use of policies generally termed difference-in-conditions insurance (DIC). The DIC policy insures property and liability losses not covered by basic insurance contracts. It can be written to insure almost any peril, including earthquake and flood, subject to deductibles and stated exclusions. It is often written on an all-risk basis. An international business firm may use the DIC to secure uniform coverage for all countries in which it operates and to obtain higher policy limits than those available from domestic insurers in the various foreign countries.
Surety contracts are designed to protect businesses against the possible dishonesty of their employees. Surety and fidelity bonds fill the gap left by theft insurance, which always excludes losses from persons in a position of trust. A bond involves three contracting parties instead of two. The three parties are the principal, who is the person bonded; the obligee, the person who is protected; and the surety, the person or corporation agreeing to reimburse the obligee for any losses stemming from failures or dishonesty of the principal. The bond covers events within the control of the person bonded, whereas insurance in the strict sense covers loss from random events generally outside the direct control of the insured. In bonding, the surety always has the right to try to collect its losses from the person bonded, whereas in insurance the insurer may not attempt to recover losses from the insured. Of course, under property and liability policies the insurer may attempt to recover from liable third parties under the right of subrogation, but subrogation rights are often not possible to enforce in practice. Bonds are not usually cancelable by the insurer, whereas most insurance contracts, except life, are cancelable by the insurer upon due notice.
Fidelity bonds are written to cover the obligee, usually an employer, against loss from dishonest acts of employees; surety bonds cover not only dishonesty but also incapacity to perform the work agreed upon. Surety bonds are normally written on principals who are acting in an independent or semi-independent capacity, such as building contractors or public officials, whereas fidelity bonds are written on employees acting under the guidance and supervision of their employer. Finally, surety bonds are often issued with the requirement of collateral, whereas fidelity bonds are not. The surety bond is an instrument through which the superior credit of the surety is substituted for the uncertain credit of the principal; hence, if the surety is asked to bond a principal of somewhat doubtful credit, the requirement of cash collateral is frequently imposed.
Major types of fidelity bonds
Fidelity bonds differ according to whether specific persons are named as principals or whether all employees or persons are covered as a group. The latter are most frequently used by employers with a large number of employees, because they offer automatic coverage on given classes of workers, including new employees, and greater ease of administration, including simpler claims procedures. Fidelity bonds are usually written on a continuous basis—that is, they are effective until canceled and have no expiration date. The penalty of the bond (the maximum amount payable for any one loss) is unchanged from year to year and is not cumulative. The bonds specify a discovery period (usually two years) limiting the time for discovering losses after a bond is discontinued. When a new bond is put into effect, it can be written to cover losses that have occurred but are undiscovered before the effective issue date of the bond. A salvage clause also is included, stating the way in which any salvage recovered by the surety from the principal is to be divided between the surety and the obligee. This clause is significant, because the obligee may have losses in excess of the penalty of the bond. Some salvage clauses require that any salvage be paid to the obligee up to the full amount of all losses, and others provide that any salvage be divided between the surety and the obligee on a pro rata basis, in the proportion that each party has suffered loss.
Major types of surety bonds
There are various classes of surety bonds. Contract construction bonds are written to guarantee the performance of contractors on building projects. Bonds are particularly important in this field because of the general practice of awarding commercial building contracts to the lowest bidder, who may promise more than can actually be performed. The surety who is experienced in this field is in a position to make sounder judgment about the liability of the various bidders than anyone else and backs up its judgment with a financial guarantee.
Court bonds include several different types of surety bonds. Fiduciary bonds are required for court-appointed officials entrusted with managing the property of others; executors of estates and receivers in bankruptcy are frequently required to post fiduciary bonds.
Other types of surety bonds include official bonds, lost instrument bonds, and license and permit bonds. Public official bonds guarantee that public officials will faithfully and honestly discharge their obligations to the state or to other public agencies. Lost instrument bonds guarantee that if a lost stock certificate, money order, warehouse receipt, or other financial instrument falls into unauthorized hands and causes a loss to the issuer of a substitute instrument, this loss will be reimbursed. License and permit bonds are issued on persons such as owners of small businesses to guarantee reimbursement for violations of the licenses or permits under which they operate.
Life and health insurance
Life insurance may be defined as a plan under which large groups of individuals can equalize the burden of loss from death by distributing funds to the beneficiaries of those who die. From the individual standpoint life insurance is a means by which an estate may be created immediately for one’s heirs and dependents. It has achieved its greatest acceptance in Canada, the United States, Belgium, South Korea, Australia, Ireland, New Zealand, the Netherlands, and Japan, countries in which the face value of life insurance policies in force generally exceeds the national income.
In the United States in 1990 nearly $9.4 trillion of life insurance was in force. The assets of the more than 2,200 U.S. life insurance companies totaled nearly $1.4 trillion, making life insurance one of the largest savings institutions in the United States. Much the same is true of other wealthy countries, in which life insurance has become a major channel of saving and investment, with important consequences for the national economy.
Life insurance is relatively little used in poor countries, although its acceptance has been increasing.
Types of contracts
The major types of life insurance contracts are term, whole life, and universal life, but innumerable combinations of these basic types are sold. Term insurance contracts, issued for specified periods of years, are the simplest. Protection under these contracts expires at the end of the stated period, with no cash value remaining. Whole life contracts, on the other hand, run for the whole of the insured’s life and gradually accumulate a cash value. The cash value, which is less than the face value of the policy, is paid to the policyholder when the contract matures or is surrendered. Universal life contracts, a relatively new form of coverage introduced in the United States in 1979, have become a major class of life insurance. They allow the owner to decide the timing and size of the premium and amount of death benefits of the policy. In this contract, the insurer makes a charge each month for general expenses and mortality costs and credits the amount of interest earned to the policyholder. There are two general types of universal life contracts, type A and type B. In type-A policies the death benefit is a set amount, while in type-B policies the death benefit is a set amount plus whatever cash value has been built up in the policy.
Life insurance may also be classified, according to type of customer, as ordinary, group, industrial, and credit. The ordinary insurance market includes customers of whole life, term, and universal life contracts and is made up primarily of individual purchasers of annual-premium insurance. The group insurance market consists mainly of employers who arrange group contracts to cover their employees. The industrial insurance market consists of individual contracts sold in small amounts with premiums collected weekly or monthly at the policyholder’s home. Credit life insurance is sold to individuals, usually as part of an installment purchase contract; under these contracts, if the insured dies before the installment payments are completed, the seller is protected for the balance of the unpaid debt.
Insurance may be issued with a premium that remains the same throughout the premium-paying period, or it may be issued with a premium that increases periodically according to the age of the insured. Practically all ordinary life insurance policies are issued on a level-premium basis, which makes it necessary to charge more than the true cost of the insurance in the earlier years of the contract in order to make up for much higher costs in the later years; the so-called overcharges in the earlier years are not really overcharges but are a necessary part of the total insurance plan, reflecting the fact that mortality rates increase with age. The insured is not overpaying for protection, because of the claim on the cash values that accumulate in the early years; the policyholder may borrow on this value or may recapture it completely by lapsing the policy. The insured does not, however, have a claim on all the earnings that accrue to the insurance company from investing the funds of its policyholders.
By combining term and whole life insurance, an insurer can provide many different kinds of policies. Two examples of such “package” contracts are the family income policy and the mortgage protection policy. In each of these, a base policy, usually whole life insurance, is combined with term insurance calculated so that the amount of protection declines as the policy runs its course. In the case of the mortgage protection contract, for example, the amount of the decreasing term insurance is designed roughly to approximate the amount of the mortgage on a property. As the mortgage is paid off, the amount of insurance declines correspondingly. At the end of the mortgage period the decreasing term insurance expires, leaving the base policy still in force. Similarly, in a family income policy, the decreasing term insurance is arranged to provide a given income to the beneficiary over a period of years roughly corresponding to the period during which the children are young and dependent.
Some whole life policies permit the insured to limit the period during which premiums are to be paid. Common examples of these are 20-year life, 30-year life, and life paid up at age 65. On these contracts, the insured pays a higher premium to compensate for the limited premium-paying period. At the end of the stated period, the policy is said to be “paid up,” but it remains effective until death or surrender.
Term insurance is most appropriate when the need for protection runs for only a limited period; whole life insurance is most appropriate when the protection need is permanent. The universal life plan, which earns interest at a rate roughly equal to that earned by the insurer (approximately the rate available in long-term bonds and mortgages), may be used as a convenient vehicle by which to save money. The owner can vary the amount of death protection as the need for it changes in the course of life. The policy offers flexibility and saves the owner commission expense by eliminating the need for dropping one policy and taking out another as protection requirements change.
The death proceeds or cash values of insurance may be settled in various ways. The insured may take the cash value and lapse the policy. A beneficiary may take a lump sum settlement of the face amount upon the death of the insured. The beneficiary may, instead, elect to receive the proceeds over a given number of years or in some fixed amount, such as $100 a month, for as long as the proceeds last. The money may be left with the insurer temporarily to draw interest. Or the proceeds may be used to purchase a life annuity, which in effect is another insurance policy guaranteeing regular payments for the life of the insured.
Life insurance policies contain various clauses that protect the rights of beneficiaries and the insured. Perhaps the best-known is the incontestable clause, which provides that if a policy has been in force for two years the insurer may not afterward refuse to pay the proceeds or cancel the contract for any reason except nonpayment of premiums. Thus, if the insured made a material misrepresentation when the policy was originally obtained, and this misrepresentation is not discovered until after the contestable period, beneficiaries may still receive the value of the policy so long as the premiums are maintained. Another protective clause is the suicide clause, which states that after a given period, usually two years, the insurer may not deny liability for subsequent suicide of the insured. If suicide occurs within the period, the insurer tenders to the beneficiary only the premiums that have been paid. If the age of the insured was misstated when the policy was taken out, the misstatement-of-age clause provides that the amount payable is the amount of insurance that would have been purchased for the premium had the correct age been stated. Many life insurance policies, known as participating policies, return dividends to the insured. The dividends, which may amount to 20 percent of the premiums, may be accumulated in cash left with the insurer at interest, used to buy additional life insurance, used to reduce premium payments, or used to pay up the contract sooner than would otherwise have been possible.
The insured may, at a nominal charge, attach to the contract a waiver-of-premium rider under which premium payments will be waived in the event of total and permanent disability before the age of 60. Under the disability income rider, should the insured become totally and permanently disabled, a monthly income will be paid. Under the double indemnity rider, if death occurs through accident, the insurance payable is double the face amount.
Private health insurance
In many countries health insurance has become a governmental institution. In some, doctors and other professional staff are employed, directly or indirectly, by a government agency on a full-time or part-time salaried basis, and health facilities are owned or operated by the government. This has been the practice in Australia, Brazil, Canada, Chile, Greece, Ireland, Mexico, New Zealand, Sweden, Turkey, and the countries of eastern Europe. In other countries the government pays for medical care provided by private physicians; these countries include Austria, Denmark, the Netherlands, Norway, and Spain. In some countries private health insurance programs exist along with, or as part of, the government program. Various combinations of programs are possible, and it is difficult to summarize all the arrangements that actually exist.
The United States provides government-run medical services in veterans’ hospitals and mental hospitals, and it also has a governmental health insurance program for citizens age 65 and over (Medicare) under the Social Security Act amendments of 1965, but most health insurance in the United States still consists of private programs. Much private health insurance in the United States is operated on a group basis, generally through groups of employees whose payments may be subsidized by their employer. The following is a description of the principles of private health insurance. Government medical services are discussed in the article social security: government welfare programs.