Insurance

Insurance is a contract in which one party, the policyholder, pays a regular or one-off sum called a premium to another, the insurer, in return for a promise that the insurer will pay out if a specified loss happens. Covered events range from death, illness and accidents to fire, theft, crop failure, shipping losses and legal liability. Insurance lets households and businesses swap an uncertain, possibly ruinous loss for a known, affordable cost.

Insurers are a major class of institutional investor, because they invest premiums until claims are paid. The industry is usually divided into life insurance, non-life or general insurance (property, motor, liability, health in many countries) and reinsurance, which insures insurers. Islamic finance offers a mutual alternative called takaful. Economists study insurance as a way of sharing risk among people who are risk averse. Newer InsurTech firms use online and embedded distribution, telematics data and automated claims handling to change how these products are sold, priced and paid out.

Imagine a street of a hundred houses. Every year one of them, nobody knows which, suffers a burst pipe that costs a lot to fix. If every household puts a small amount into a shared jar at the start of the year, the jar can pay for whichever house is unlucky, and nobody faces the full bill alone.

An insurance company runs that jar for millions of people. It works out roughly how often each kind of misfortune happens, sets the contribution at a level that covers expected claims and its own costs, and pays out to the few who need it. Most people pay in more than they get back in a typical year, and they accept that in exchange for peace of mind.

Insurance relies on the law of large numbers: although one person's loss is unpredictable, the average loss across many similar policies is fairly stable. Actuaries estimate the expected loss and add loadings for costs and profit. A simplified pure premium is:

• $p$ is the probability that the insured event happens during the policy period.
• $L$ is the average loss if it does happen.

If 1 home in 200 suffers a fire each year ($p = 0.005$) and the average fire claim is $40,000, the pure premium is $0.005 \times 40{,}000 = 200$ dollars. The insurer then adds an amount for administration, commissions, reinsurance, capital and profit, so the price charged might be $260. Because premiums arrive before claims, insurers also earn investment income on the "float", mostly from government and corporate bonds.

• Life insurance and annuities. Term and whole-life policies pay on death; annuities pay income for life and protect against outliving savings.
• Health insurance. Private or state-run schemes pay medical costs; in many countries it is compulsory or provided through employers.
• Property and casualty. Home, motor, business property and liability cover, including professional indemnity and marine cover such as protection and indemnity.
• Credit and financial insurance. Trade credit insurance, mortgage insurance, deposit insurance and financial guarantees protect against borrowers failing to pay.
• Social insurance. Governments run unemployment, pension and disability schemes funded by contributions, linked to welfare systems.

Insurance markets face two classic problems arising from asymmetric information. Adverse selection occurs because people who know they are high-risk are keener to buy cover, which can push premiums up and drive low-risk buyers out, a dynamic similar to the market for lemons. Moral hazard occurs because insured people may take less care once they are covered. Insurers respond with underwriting questions, risk-based pricing, deductibles, co-payments, waiting periods and, in health insurance, compulsory or employer-wide cover.

Marine insurance contracts were written in Italian trading cities by the fourteenth century. Fire insurance spread in London after the Great Fire of 1666, and Lloyd's of London grew from Edward Lloyd's coffee house, where shipowners and underwriters met from the late 1680s. Life insurance became widespread in the nineteenth century as mortality tables improved.

Insurers are regulated to make sure they can pay claims decades ahead. The EU's Solvency II regime, applied since 2016, sets risk-based capital rules; the United States regulates insurance mainly at state level, coordinated through the National Association of Insurance Commissioners; and the International Association of Insurance Supervisors sets global standards. In Pakistan the Securities and Exchange Commission of Pakistan supervises insurers. The near-collapse of AIG in 2008, caused largely by credit default swaps written by a non-insurance unit, showed that large insurance groups can contribute to systemic risk.

Some risks are hard to insure because losses are correlated, such as pandemics, floods and war, so governments often act as backstops through schemes such as Flood Re in the UK or terrorism reinsurance pools. Climate change is raising premiums and causing insurers to withdraw from some high-risk areas, which raises questions about affordability and who should bear the cost.

• International Association of Insurance Supervisors (IAIS)
• European Insurance and Occupational Pensions Authority (EIOPA)