This post discusses insurance and the roles of insurance as a risk management strategy.

WHAT IS AN INSURANCE CONTRACT?
A contract is a legally binding agreement between two or more parties whereby rights are acquired by one or more parties to act or forbearances on the part of the other. Insurance is a contract between two parties, the insured and the insurer, whereby the insurer undertakes to make good a loss of the insured caused by specified perils during the contract period in exchange for a consideration known as the premium.

Insurance is the pooling of fortuitous losses by transferring the risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk. Individuals, households, and businesses can purchase insurance policies to manage risk exposures. Hence, insurance may be considered as the custodian or treasurer of the fund.

FUNCTIONS OF INSURANCE
Essential functions of insurance include risk transfer, common pool, security, investment enhancement, loss control and savings.

BENEFITS OF INSURANCE
Insurance benefits include payment of a loss, reduction of uncertainty, ensuring compliance with legal requirements, promoting loss control activity, efficient use of insureds’ financial resources, and reduced social burden through compensating insured accident victims.

INSURABLE RISKS
Insurers cannot insure all risks. Risks that can be transferred to or insured with insurers are known as insurable risks, while risks that cannot be transferred to or insured by insurers are known as uninsurable risks. Insurable risks must possess the features or characteristics of insurable risks.

FEATURES OF INSURABLE RISKS
Insurable risks include financial value, insurable interest, fortuitous, homogeneous exposure, losses must not be catastrophic in nature, consistency with the public policy or the law, particular and fundamental risks, and reasonable premium.

HOW INSURANCE OPERATES
Insurance operates based on four key ingredients: risk transfer, creation of common pools – Laws of large numbers, charging of equitable premiums, and avoidance of adverse selection.

ADVERSE SELECTION AGAINST INSURERS
Adverse selection is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average) rates. If not controlled by underwriting, it results in higher-than-expected loss levels.

HOW DO INSURERS COPE WITH ADVERSE SELECTION?
Methods of dealing with adverse selection by insurers include: (1) seeking information disclosure, (2) selecting a ‘niche’ market or class of insurance, and (3) prudent underwriting, and (4) Effective use of insurance policy conditions.

LEGAL PRINCIPLES OF INSURANCE
The nature of legal principles of insurance varies from country to country, but essential legal principles of insurance are utmost good faith, insurable interest, indemnity, subrogation, contribution, and proximate cause. Now, let us briefly examine the legal principles of insurance.

CATEGORISATION OF INSURANCE CONTRACTS
Businesses can purchase two categories of insurance policies to manage risks: (1) Traditional insurance contracts; and (2) Loss sensitive insurance contracts.

TRADITIONAL INSURANCE CONTRACTS
Traditional insurance contracts are insurance contracts whose premiums depend on the value at risk and feature of the subject matter insured (i.e., the item or risk insured) at the inception of the insurance contract. Loss-sensitive insurance contracts are insurance contracts whose premiums depend on the loss experienced by the policy.

Examples of traditional insurance contracts include fire insurance, theft insurance, money insurance, credit insurance, business interruption insurance, contractors-all-risk insurance, goods-in-transit insurance, engineering insurance, motor insurance, marine insurance, aviation insurance, public liability insurance, product liability insurance, professional indemnity insurance, employers liability insurance, directors and officers liability, contingency insurance, life insurance, sickness, and accident insurance.

LOSS SENSITIVE INSURANCE CONTRACTS
Loss sensitive insurance contract is an insurance policy whose premiums depend on the loss experienced. Loss sensitive insurance contract is an insurance rating for which the final premium depends on the actual losses during the period the plan is in effect.

This risk financing technique places upper limits on the insured’s costs if its losses are high but also requires the payment of a minimum premium if it experiences low losses or is loss-free. Hence, the risk and premium of loss-sensitive insurance contracts vary based on the actual loss experience.

Loss sensitive insurance incentivises firms to emphasise safety and loss control activities. With a loss-sensitive structure, a firm pays a lower premium in exchange for partial coverage of a loss in excess of its deductible. The organisation can further reduce retained costs by improving safety and claims-handling procedures.

ADVANTAGES OF LOSS-SENSITIVE INSURANCE
Advantages of Loss-sensitive Insurance include lower premiums, savings through loss control and claims handling, improved cash flow and investment income, price stability, and lower cost of risk. Examples of loss-sensitive plans include deductible plans, retrospective rating plans, dividend plans, and retention plans.