Insurance, legal contract that protects people from the financial costs that result from loss of life, loss of health, lawsuits, or property damage. Insurance provides a means for individuals and societies to cope with some of the risks faced in everyday life. People purchase contracts of insurance, called policies, from a variety of insurance organizations.
Almost everyone living in modern, industrialized countries buys insurance. For instance, laws in most states require people who own a car to buy insurance before driving it on public roads. Lenders require anyone who finances the purchase of a home or car with borrowed money to insure that property. Business partners take out life insurance on each other to make sure the business will succeed even if one of the partners dies.
Insurance makes up part of the broader financial services industry (see Finance). In the United States in the late-1990s, more than 5500 insurance companies offered a wide range of policies and services. Some large companies sell virtually every type of insurance available in the marketplace. Smaller companies may specialize in a specific geographic region or type of insurance. In 1997 more than 300 Canadian companies sold some form of insurance.
REASONS FOR INSURANCEIn life, losses are sometimes unavoidable. People may become ill and lose income or savings to pay off medical bills. Individuals or their relatives may die of illness or accidents. People’s homes or other property may suffer damage or theft. People also may accidentally cause injury to others or damage to the property of others.
No one knows in advance when a loss will occur or how serious that loss will be. The uncertainty surrounding potential losses is known as risk. Insurance offers a way for people to replace risk with known costs—the costs of buying and maintaining insurance policies.
Assume a person buys a new car for $25,000. Its owner faces the possibility that, at some point, the car will suffer damage in an accident. But how could the owner budget in advance for a loss of unknown cost? The cost to repair or replace the car in the event of an accident could range from the price of a bottle of touch-up paint to as much as $25,000. If the accident injures someone, the costs of medical care could be much higher. Through the mechanism of insurance, however, the car owner can share the risk of an accident with others who face the same risk.
Insurance pools (combines) risks shared by many people, thereby reducing the risks faced by a group. People pay to buy insurance coverage (protection from risk). In exchange, all policyholders (people who own insurance policies) receive a promise that the group of policyholders—as represented by the insurance organization—will pay when any policyholder experiences a covered loss.
The reduction in risk brought by insurance relies on a mathematical concept called the law of large numbers. That law states that the ability to predict losses improves with larger groups. Using calculations based on statistics, experts known as actuaries can accurately predict the losses of a large population, even without knowing when or how any one individual will experience loss.
Insurers distinguish between two types of risk: speculative risk and pure risk. Speculative risk offers both the potential for gain and the potential for loss. People who invest in the stock of companies, for example, take speculative risk. An increase in stock prices produces a gain, while a decline in stock prices produces a loss. Pure risk, by contrast, creates the potential only for loss. Although pure risks do not necessarily result in losses, they never result in gains.
Historically, insurance dealt only with pure risks, and most people still buy insurance to cover pure risks. No one, for instance, experiences a gain when they go a full year without an auto accident. However, some insurance companies now help businesses finance large losses including those incurred on speculative risks, such as the international exchange of currency. Also, in the 1990s financial markets and some professions outside insurance, such as the field of environmental impact and damage assessment, began to expand into risk management for the first time.
IMPORTANCE OF INSURANCE
Insurance benefits society by allowing individuals to share the risks faced by many people. But it also serves many other important economic and societal functions. Because insurance is available and affordable, banks can make loans with the assurance that the loan’s collateral (property that can be taken as payment if a loan goes unpaid) is covered against damage. This increased availability of credit helps people buy homes and cars. Insurance also provides the capital that communities need to quickly rebuild and recover economically from natural disasters, such as tornadoes or hurricanes.
Insurance itself has become a significant economic force in most industrialized countries. Employers buy insurance to cover their employees against work-related injuries and health problems. Businesses also insure their property, including technology used in production, against damage and theft. Because it makes business operations safer, insurance encourages businesses to make economic transactions, which benefits the economies of countries. In addition, millions of people work for insurance companies and related businesses. In 1996 more than 2.4 million people worked in the insurance industry in the United States and Canada.
Insurance companies perform a type of monetary redistribution—they collect premiums and eventually redistribute that money as payments. Depending on the type of insurance, redistribution can take anywhere from a few months to many decades. Because of this delay between collecting and paying out funds, insurance companies invest their funds to bring in extra revenues. Such investments help businesses and governments finance their operations, and profits from those investments support the operations of insurance companies. With these investment earnings, insurance companies can keep rates much lower than would otherwise be possible.
Not all effects of insurance are positive ones. The possibility of earning insurance payments motivates some people to attempt to cause damage or losses. Without the possibility of collecting insurance benefits, for instance, no one would think of arson, the willful destruction of property by fire, as a potential source of money.
