Insurance

• 1. Introduction

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  On the 18th of June 1583, in the Royal Exchange in London, a contract was written on the life of a man named William Gibbons. It promised 383 pounds, 6 shillings and 8 pence if he died within twelve months. This is the earliest known policy of life insurance. The idea behind it stretches back thousands of years. Chinese merchants once split their cargo across many boats so that one capsized vessel would not ruin them. Indian traders practiced their own forms of risk-sharing in the 3rd and 2nd millennia BC. From those scattered habits grew a vast machinery of premiums, claims, and reserves that now writes trillions of dollars in coverage every year. How did a promise to make someone whole again become a global financial industry? What does it actually take for a risk to be insurable? And how do companies that exist to pay out losses end up making money? The answers run through fires, coffee houses, river rapids, and the careful arithmetic of probability.

• 2. How Insurance Works

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  A policyholder pays a small, known sum so that an insurer will cover a large, uncertain loss. That trade is the heart of every insurance contract. The fee is called the premium, and in return the insurer issues a policy spelling out exactly when and how it will pay. The loss itself does not have to be financial, but it must always be reducible to financial terms. It must also involve something in which the insured holds an insurable interest, established by ownership, possession, or a pre-existing relationship. When a covered loss happens, the insured submits a claim, which a claims adjuster then processes. Many policies require the insured to pay a fixed amount first, called a deductible or excess, or a copayment under health insurance. The whole system runs on pooling. Funds from many insured entities cover the losses that only some will suffer, a process known as a risk pool. Because predicted losses across a large group tend to match actual losses, insurers benefit from the law of large numbers. When a single risk grows too large to carry, the insurer can buy reinsurance, passing part of it to another company called the reinsurer.

• 3. What Makes A Risk Insurable

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  Seven characteristics tend to separate an insurable risk from one no private company will touch. The first is a large number of similar exposure units, since pooling only works across big classes of like risks. Lloyd's of London is the famous exception, willing to insure the life or health of actors, sports figures, and other celebrated individuals. A definite loss is the second trait, one that strikes at a known time and place from a known cause, like the death of an insured person. Occupational disease tests this rule, because prolonged exposure to harmful conditions may have no single identifiable moment. Accidental loss is the third, meaning the trigger should be fortuitous and outside the beneficiary's control. Buying a lottery ticket or running ordinary business risk carries speculative elements, and so it stays outside the bounds of insurance. The loss must also be large enough to matter, because for tiny losses the cost of administering a policy can dwarf the loss itself. The premium must stay affordable, and there must remain a real chance of loss to the insurer, a point the U.S. Financial Accounting Standards Board addressed in its pronouncement number 113. The loss must be calculable in both probability and cost. Finally, insurable losses should be independent and non-catastrophic, which is why capital constraints limit the sale of earthquake and hurricane wind insurance, and why the federal government insures flood risk in specifically identified areas.

• 4. From The Great Fire To Lloyd's

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  In 1666 the Great Fire of London devoured more than 13,000 houses, and property insurance as we know it traces to that disaster. The fire turned insurance from a matter of convenience into one of urgency. Sir Christopher Wren even reserved a site for the Insurance Office in his 1667 plan for London. In 1681 the economist Nicholas Barbon and eleven associates founded the first fire insurance company, the Insurance Office for Houses, set up at the back of the Royal Exchange to cover brick and frame homes. Around 5,000 homes were insured by that office at the start. In the late 1680s Edward Lloyd opened a coffee house that drew the parties of the shipping trade, those wishing to insure cargoes and ships and those willing to underwrite them. From that gathering grew the market known as Lloyd's of London. Life insurance organized itself soon after. The Amicable Society for a Perpetual Assurance Office, founded in London in 1706 by William Talbot and Sir Thomas Allen, was the first company to offer it. In 1762 Edward Rowe Mores established the Society for Equitable Assurances on Lives and Survivorship, the world's first mutual insurer, which pioneered age-based premiums tied to mortality rate. Accident insurance arrived later, when the Railway Passengers Assurance Company formed in 1848 to insure against the rising number of deaths on the new railways.

• 5. Ancient Roots

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  Codex Hammurabi Law 238, dated to roughly 1755 to 1750 BC, ruled that a sea captain who saved a ship from total loss owed the owner only half the vessel's value. That early balancing of loss survives in the legal record. In the Digesta seu Pandectae of 533, part of the codification ordered by Justinian I, a Roman jurist named Paulus preserved a legal opinion from 235 AD about the Lex Rhodia. That Rhodian law set out the general average principle of marine insurance, established on the island of Rhodes around 1000 to 800 BC. The law of general average remains the fundamental principle underlying all insurance. An archeological dig in Minya, Egypt in 1816 turned up a tablet from the Temple of Antinous, prescribing the dues of a burial society collegium founded in Lanuvium around 133 AD during the reign of Hadrian. In 1851, Joseph P. Bradley, once an actuary for the Mutual Benefit Life Insurance Company and later a U.S. Supreme Court Associate Justice, submitted an article describing a Roman life table compiled by the jurist Ulpian around 220 AD. The ancient Greeks ran marine loans, advancing money on a ship or cargo to be repaid with heavy interest if the voyage prospered and not at all if the ship was lost. Demosthenes described these fully, and such arrangements lived on as bottomry and respondentia bonds. Direct insurance of sea-risks for a premium began in Belgium about 1300 AD, and the first known insurance contract dates from Genoa in 1347.

• 6. The Insurer's Business Model

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  Insurers aim to collect more in premiums than they pay out in losses, while still offering a price consumers will accept. The hardest part of this is the actuarial science of ratemaking, which uses statistics and probability to estimate future claims for a given risk. After setting rates, the insurer applies underwriting to accept or reject risks, weighing historical loss data brought to present value against the premium collected. Underwriting performance is measured by the combined ratio, the ratio of expenses and losses to premiums. A combined ratio under 100% means an underwriting profit, while anything over 100 means an underwriting loss. There is a second way insurers earn money, and it can rescue a company whose underwriting loses. They invest the premiums they collect, earning returns on what is called float, the money held after collecting premiums but before paying claims. In 2007, U.S. industry profits from float totaled 58 billion dollars. In a 2009 letter to investors, Warren Buffett wrote that his company was paid 2.8 billion dollars to hold its float in 2008. Over the five years ending in 2003, U.S. property and casualty insurers ran an underwriting loss of 142.3 billion dollars, yet posted overall profit of 68.4 billion dollars thanks to float. Not everyone trusts this. Hank Greenberg, among others, doubted that float alone could sustain profit forever without underwriting profit too. The swing between profitable and unprofitable stretches is known as the underwriting cycle.

• 7. When A Claim Comes In

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  Claims handling is the materialized utility of insurance, the actual product a policyholder pays for. Claims may arrive directly or through brokers and agents, sometimes on a company's own forms and sometimes on a standard industry form such as those produced by ACORD. A claims adjuster investigates each one, usually working closely with the insured, decides whether coverage applies, sets the reasonable value, and authorizes payment. Policyholders may hire their own public adjusters to negotiate settlements on their behalf. For complex policies, the insured can even buy loss recovery insurance to cover the cost of that public adjuster. Liability claims are the thorniest, because they involve a third party, the plaintiff, who has no contractual duty to cooperate and may treat the insurer as a deep pocket. The adjuster must arrange legal counsel, inside or outside the company, and monitor litigation that can drag on for years. Several long-standing legal principles govern these settlements. Indemnity compensates the insured only up to their interest, while subrogation lets the insurer pursue those responsible for the loss. Utmost good faith binds both sides to honesty and full disclosure of material facts. Insurable interest, the requirement that the insured truly suffer from the loss, is the very thing that separates insurance from gambling.

• 8. A Catalog Of Coverage

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  Any risk that can be quantified can potentially be insured, and the specific events that trigger claims are called perils. Vehicle insurance bundles property coverage for the car, liability coverage for harm to others, and medical coverage for injuries. GAP insurance, short for Guaranteed Asset Protection, covers the leftover balance on an auto loan, marketed to buyers with low down payments and terms of 60 months or longer. Property insurance fans out into dozens of forms, from earthquake and flood to aviation, boiler, crop, and title insurance. Many U.S. insurers will not write flood coverage in some areas, so the federal government created the National Flood Insurance Program as the insurer of last resort. Burial insurance is among the oldest of all. The Greeks and Romans introduced it around 600 CE through collegia, benevolent societies that paid funeral costs and cared for surviving families, a role later filled by medieval guilds and Victorian friendly societies. Life insurance differs in kind, since it is not indemnity insurance but contingent insurance, paying out when a specified event occurs. The strangest entries read like a tour of human anxiety. Kidnap and ransom insurance guards against extortion and hijacking in high-risk regions. Prize indemnity insurance protects a business that offers a half-court shot or a hole-in-one. Divorce insurance pays a cash benefit if a marriage ends. Across the whole industry, Swiss Re reported that the global insurance market wrote 7.186 trillion dollars in direct premiums in 2023, with the United States alone accounting for 3.226 trillion of that total.