Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a potential loss, from one entity to another, in exchange for a premium. Insurer, in economics, is the company that sells the insurance. Insurance rate is a factor used to determine the amount, called the premium, to be charged for a certain amount of insurance coverage. Risk management, the practice of appraising and controlling risk, has evolved as a discrete field of study and practice.
Contents[hide]
1 Principles of insurance
2 Indemnification
3 When is a Policy Really Insurance?
3.1 Does the Contract Contain Adequate Risk Transfer?
3.2 Is There a Brightline Test?
3.3 "Safe Harbor Exemptions"
3.4 Risk Limiting Features
4 Insurer’s business model
5 Gambling analogy
6 History of insurance
7 Types of insurance
8 Types of insurance companies
9 Life insurance and saving
10 Size of global insurance industry
11 Financial viability of insurance companies
12 Controversies
12.1 Insurance insulates too much
12.2 Closed community self-insurance
12.3 Complexity of insurance policy contracts
12.4 Redlining
12.5 Health insurance
12.6 Dental insurance
12.7 Insurance patents
12.8 The insurance industry and rent seeking
13 Glossary
14 Quote
15 References
16 See also
16.1 Lists
17 External links
//
[edit] Principles of insurance
Commercially insurable risks typically share seven common characteristics. [1]
A large number of homogeneous exposure units. The vast majority of insurance policies are provided for individual members of very large classes. Automobile insurance, for example, covered about 175 million automobiles in the United States in 2004. The existence of a large number of homogeneous exposure units allows insurers to benefit from the so-called “law of large numbers,” which in effect states that as the number of exposure units increases, the actual results are increasingly likely to become close to expected results. There are exceptions to this criterion. Lloyds of London is famous for insuring the life or health of actors, actresses and sports figures. Satellite Launch insurance covers events that are infrequent. Large commercial property policies may insure exceptional properties for which there are no ‘homogeneous’ exposure units. Despite failing on this criterion, many exposures like these are generally considered to be insurable.
Definite Loss. The event that gives rise to the loss that is subject to insurance should, at least in principle, take place at a known time, in a known place, and from a known cause. The classic example is death of an insured on a life insurance policy. Fire, automobile accidents, and worker injuries may all easily meet this criterion. Other types of losses may only be definite in theory. Occupational disease, for instance, may involve prolonged exposure to injurious conditions where no specific time, place or cause is identifiable. Ideally, the time, place and cause of a loss should be clear enough that a reasonable person, with sufficient information, could objectively verify all three elements.
Accidental Loss. The event that constitutes the trigger of a claim should be fortuitous, or at least outside the control of the beneficiary of the insurance. The loss should be ‘pure,’ in the sense that it results from an event for which there is only the opportunity for cost. Events that contain speculative elements, such as ordinary business risks, are generally not considered insurable.
Large Loss. The size of the loss must be meaningful from the perspective of the insured. Insurance premiums need to cover both the expected cost of losses, plus the cost of issuing and administering the policy, adjusting losses, and supplying the capital needed to reasonably assure that the insurer will be able to pay claims. For small losses these latter costs may be several times the size of the expected cost of losses. There is little point in paying such costs unless the protection offered has real value to a buyer.
Affordable Premium. If the likelihood of an insured event is so high, or the cost of the event so large, that the resulting premium is large relative to the amount of protection offered, it is not likely that anyone will buy insurance, even if on offer. Further, as the accounting profession formally recognizes in financial accounting standards (See FAS 113 for example), the premium cannot be so large that there is not a reasonable chance of a significant loss to the insurer. If there is no such chance of loss, the transaction may have the form of insurance, but not the substance.
Calculable Loss. There are two elements that must be at least estimatable, if not formally calculable: the probability of loss, and the attendant cost. Probability of loss is generally an empirical exercise, while cost has more to do with the ability of a reasonable person in possession of a copy of the insurance policy and a proof of loss associated with a claim presented under that policy to make a reasonably definite and objective evaluation of the amount of the loss recoverable as a result of the claim.
Limited risk of catastrophically large losses. The essential risk is often aggregation. If the same event can cause losses to numerous policyholders of the same insurer, the ability of that insurer to issue policies becomes constrained, not by factors surrounding the individual characteristics of a given policyholder, but by the factors surrounding the sum of all policyholders so exposed. Typically, insurers prefer to limit their exposure to a loss from a single event to some small portion of their capital base, on the order of 5%. Where the loss can be aggregated, or an individual policy could produce exceptionally large claims, the capital constraint will restrict an insurers appetite for additional policyholders. The classic example is earthquake insurance, where the ability of an underwriter to issue a new policy depends on the number and size of the policies that it has already underwritten. Wind insurance in hurricane zones, particularly along coast lines, is another example of this phenomenon. In extreme cases, the aggregation can effect the entire industry, since the combined capital of insurers and reinsurers can be small compared to the needs of potential policyholders in areas exposed to aggregation risk. In commercial fire insurance it is possible to find single properties whose total exposed value is well in excess of any individual insurer’s capital constraint. Such properties are generally shared among several insurers, or are insured by a single insurer who syndicates the risk into the reinsurance market.
[edit] Indemnification
An entity seeking to transfer risk (an individual, corporation, or association of any type, etc.) becomes the 'insured' party once risk is assumed by an 'insurer', the insuring party, by means of a contract, called an insurance 'policy'. Generally, an insurance contract includes, at a minimum, the following elements: the parties (the insurer, the insured, the beneficiaries), the premium, the period of coverage, the particular loss event covered, the amount of coverage (i.e., the amount to be paid to the insured or beneficiary in the event of a loss), and exclusions (events not covered). An insured is thus said to be "indemnified" against the loss events covered in the policy.
When insured parties experience a loss for a specified peril, the coverage entitles the policyholder to make a 'claim' against the insurer for the covered amount of loss as specified by the policy. The fee paid by the insured to the insurer for assuming the risk is called the 'premium'. Insurance premiums from many insureds are used to fund accounts reserved for later payment of claims—in theory for a relatively few claimants—and for overhead costs. So long as an insurer maintains adequate funds set aside for anticipated losses (i.e., reserves), the remaining margin is an insurer's profit.
[edit] When is a Policy Really Insurance?
“Insurance provides indemnification against loss or liability from specified events and circumstances that may occur or be discovered during a specified period. ”
-- FASB Statement of Financial Accounting Standards No. 113, “Accounting for Reinsurance of Short-Duration and Long-Duration Contracts” December 1992
An operational definition of insurance is that it is
the benefit provided by a particular kind of indemnity contract, called an insurance policy;
that is issued by one of several kinds of legal entities (stock company, mutual company, reciprocal, or Lloyds organization, for example), any of which may be called an insurer;
in which the insurer promises to pay on behalf of or to indemnify another party, called a policyholder or insured;
that protects the insured against loss caused by those perils subject to the indemnity in exchange for consideration known as an insurance premium.
In recent years this kind of operational definition proved inadequate as a result of contracts that had the form but not the substance of insurance. The essence of insurance is the transfer of risk from the insured to one or more insurers. How much risk a contract actually transfers proved to be at the heart of the controversy.
This issue arose most clearly in reinsurance, where the use of Financial Reinsurance to reengineer insurer balance sheets under US GAAP became fashionable during the 1980s. The accounting profession raised serious concerns about the use of reinsurance in which little if any actual risk was transferred, and went on to address the issue in FAS 113, cited above. While on its face, FAS 113 is limited to accounting for reinsurance transactions, the guidance it contains is generally conceded to be equally applicable to US GAAP accounting for insurance transactions executed by commericial enterprises.
[edit] Does the Contract Contain Adequate Risk Transfer?
FAS 113 contains two tests, called the '9a and 9b tests,' that collectively require that a contract create a reasonable chance of a significant loss to the underwriter for it to be considered insurance.
9. Indemnification of the ceding enterprise against loss or liability relating to insurance risk in reinsurance of short-duration contracts requires both of the following, unless the condition in paragraph 11 is met:
a. The reinsurer assumes significant insurance risk under the reinsured portions of the underlying insurance contracts.
b. It is reasonably possible that the reinsurer may realize a significant loss from the transaction.
Paragraph 10 of FAS 113 makes clear that the 9a and 9b tests are based on comparing the present value of all costs to the PV of all income streams. FAS gives no guidance on the choice of a discount rate on which to base such a calculation, other than to say that all outcomes tested should use the same rate.
Statement of Statutory Accounting Principles ("SSAP") 62, issued by the National Association of Insurance Commissioners, applies to so-called 'statutory accounting' - the accounting for insurance enterprises to conform with regulation. Paragraph 12 of SSAP 62 is nearly identical to the FAS 113 test, while paragraph 14, which is otherwise very similar to paragraph 10 of FAS 113, additionally contains a justification for the use of a single fixed rate for discounting purposes. The choice of an "reasonable and appropriate" discount rate is left as a matter of judgement.
[edit] Is There a Brightline Test?
Neither FAS 113 nor SAP 62 defines the terms "reasonable" or "significant." Ideally, one would like to be able to substitute values for both terms. It would be much simpler if one could apply a test of an X% chance of a loss of Y% or greater. Such tests have been proposed, including one famously attributed to an SEC official who is said to have opined in an after lunch talk that a 10% chance of a 10% loss was sufficient to establish both reasonableness and significance. Indeed, many insurers and reinsurers still apply this "10/10" test as a benchmark for risk transfer testing.
It should be obvious that an attempt to use any numerical rule such as the 10/10 test will quickly run into problems. Suppose a contract has a 1% chance of a 10,000% loss? It should be reasonably self-evident that such a contract is insurance, but it fails one half of the 10/10 test. It does not appear that any "brightline" test of reasonableness nor signifance can be constructed.
Excess of loss contracts, like those commonly used for umbrella and general liability insurance, or to insure against property losses, will typically have a low ratio of premium paid to maximum loss recoverable. This ratio (expressed as a percentage), commonly called the "rate on line" for historical reasons related to underwriting practices at Lloyds of London, will typically be low for contracts that contain reasonably self-evident risk transfer. As the ratio increases to approximate the present value of the limit of coverage, self-evidence decreases and disappears.
Contracts with low rates on line may survive modest features that limit the amount of risk transferred. As rates on line increase, such risk limiting features become increasingly important.
[edit] "Safe Harbor Exemptions"
The analysis of reasonableness and signifiance is an estimate of the probability of different gain or loss outcomes under different loss scenarios. It takes time and resources to perform the analysis, which constitutes a burden without value where risk transfer is reasonably self-evident.
Guidance exists for insurers and reinsurers, whose CEO's and CFO's attest annually as to the reinsurance agreements their firms undertake. The American Academy of Actuaries, for instance, identifies three categories of contract as outside the requirement of attestation:
Inactive contracts. If there are no premiums due nor losses payable, and the insurer is not taking any credit for the reinsurance, determining risk transfer is irrelevant.
Pre-1994 contracts. The attestation requirement only applies to contracts that were entered into, renewed or amended on or after 1 January 1994. Prior contracts need not be analyzed.
Where risk transfer is "reasonably self-evident."
"Risk transfer is reasonably self-evident in most traditional per-risk or per-occurrence excess of loss reinsurance contracts. For these contracts, a predetermined amount of premium is paid and the reinsurer assumes nearly all or all of the potential variablility in the underlying losses, and it is evident from reading the basic terms of the contract that the reinsurer can incur a significant loss. In many cases, there is no aggregate limit on the reinsurer's loss. The existence of certain experience-based contract terms, such as experience accounts, profit commissions, and additional premiums, generally reduce the amount of risk transfer and make it less likely that risk transfer is reaonably self-evident."
- "Reinsurance Attestation Supplement 20-1: Risk Transfer Testing Practice Note," American Academy of Actuaries, November 2005. ...
[edit] Risk Limiting Features
An insurance policy should not contain provisions that allow one side or the other to unilaterally void the contract in exchange for benefit. Provisions that void the contract for failure to perform or for fraud or material misrepresentation are ordinary and acceptable.
The policy should have a term of not more than about three years. This is not a hard and fast rule. Contracts of over five years duration are classified as ‘long-term,’ which can impact the accounting treatment, and can obviously introduce the possibility that over the entire term of the contract, no actual risk will transfer. The coverage provided by the contract need not cease at the end of the term (e.g., the contract can cover occurrences as opposed to claims made or claims paid).
The contract should be considered to include any other agreements, written or oral, that confer rights, create obligations, or create benefits on the part of either or both parties. Ideally, the contract should contain an ‘Entire Agreement’ clause that assures there are no undisclosed written or oral side agreements that confer rights, create obligations, or create benefits on the part of either or both parties. If such rights, obligations or benefits exist, they must be factored into the tests of reasonableness and significance.
The contract should not contain arbitrary limitations on timing of payments. Provisions that assure both parties of time to properly present and consider claims are acceptable provided they are commercially reasonable and customary.
Provisions that expressly create actual or notional accounts that accrue actual or notional interest suggest that the contract contains, in fact, a deposit.
Provisions for additional or return premium do not, in and of themselves, render a contract something other than insurance. However, it should be unlikely that either a return or additional premium provision be triggered, and neither party should have discretion regarding the timing of such triggering.
All of the events that would give rise to claims under the contract cannot have materialized prior to the inception of the contract. If this "all events" test is not met, then the contract is considered to be a retroactive contract, for which the accounting treatment becomes complex.
[edit] Insurer’s business model
Profit = earned premium + investment income - incurred loss - underwriting expenses.
Insurers make money in two ways: (1) through underwriting, the process by which insurers select the risks to insure and decide how much in premiums to charge for accepting those risks and (2) by investing the premiums they collect from insureds.
The most difficult aspect of the insurance business is the underwriting of policies. Using a wide assortment of data, insurers predict the likelihood that a claim will be made against their policies and price products accordingly. To this end, insurers use actuarial science to quantify the risks they are willing to assume and the premium they will charge to assume them. Data is analyzed to fairly accurately project the rate of future claims based on a given risk. Actuarial science uses statistics and probability to analyze the risks associated with the range of perils covered, and these scientific principles are used to determine an insurer's overall exposure. Upon termination of a given policy, the amount of premium collected and the investment gains thereon minus the amount paid out in claims is the insurer's underwriting profit on that policy. Of course, from the insurer's perspective, some policies are winners (i.e., the insurer pays out less in claims and expenses than it receives in premiums and investment income) and some are losers (i.e., the insurer pays out more in claims and expenses than it receives in premiums and investment income).
Contents[hide]
1 Principles of insurance
2 Indemnification
3 When is a Policy Really Insurance?
3.1 Does the Contract Contain Adequate Risk Transfer?
3.2 Is There a Brightline Test?
3.3 "Safe Harbor Exemptions"
3.4 Risk Limiting Features
4 Insurer’s business model
5 Gambling analogy
6 History of insurance
7 Types of insurance
8 Types of insurance companies
9 Life insurance and saving
10 Size of global insurance industry
11 Financial viability of insurance companies
12 Controversies
12.1 Insurance insulates too much
12.2 Closed community self-insurance
12.3 Complexity of insurance policy contracts
12.4 Redlining
12.5 Health insurance
12.6 Dental insurance
12.7 Insurance patents
12.8 The insurance industry and rent seeking
13 Glossary
14 Quote
15 References
16 See also
16.1 Lists
17 External links
//
[edit] Principles of insurance
Commercially insurable risks typically share seven common characteristics. [1]
A large number of homogeneous exposure units. The vast majority of insurance policies are provided for individual members of very large classes. Automobile insurance, for example, covered about 175 million automobiles in the United States in 2004. The existence of a large number of homogeneous exposure units allows insurers to benefit from the so-called “law of large numbers,” which in effect states that as the number of exposure units increases, the actual results are increasingly likely to become close to expected results. There are exceptions to this criterion. Lloyds of London is famous for insuring the life or health of actors, actresses and sports figures. Satellite Launch insurance covers events that are infrequent. Large commercial property policies may insure exceptional properties for which there are no ‘homogeneous’ exposure units. Despite failing on this criterion, many exposures like these are generally considered to be insurable.
Definite Loss. The event that gives rise to the loss that is subject to insurance should, at least in principle, take place at a known time, in a known place, and from a known cause. The classic example is death of an insured on a life insurance policy. Fire, automobile accidents, and worker injuries may all easily meet this criterion. Other types of losses may only be definite in theory. Occupational disease, for instance, may involve prolonged exposure to injurious conditions where no specific time, place or cause is identifiable. Ideally, the time, place and cause of a loss should be clear enough that a reasonable person, with sufficient information, could objectively verify all three elements.
Accidental Loss. The event that constitutes the trigger of a claim should be fortuitous, or at least outside the control of the beneficiary of the insurance. The loss should be ‘pure,’ in the sense that it results from an event for which there is only the opportunity for cost. Events that contain speculative elements, such as ordinary business risks, are generally not considered insurable.
Large Loss. The size of the loss must be meaningful from the perspective of the insured. Insurance premiums need to cover both the expected cost of losses, plus the cost of issuing and administering the policy, adjusting losses, and supplying the capital needed to reasonably assure that the insurer will be able to pay claims. For small losses these latter costs may be several times the size of the expected cost of losses. There is little point in paying such costs unless the protection offered has real value to a buyer.
Affordable Premium. If the likelihood of an insured event is so high, or the cost of the event so large, that the resulting premium is large relative to the amount of protection offered, it is not likely that anyone will buy insurance, even if on offer. Further, as the accounting profession formally recognizes in financial accounting standards (See FAS 113 for example), the premium cannot be so large that there is not a reasonable chance of a significant loss to the insurer. If there is no such chance of loss, the transaction may have the form of insurance, but not the substance.
Calculable Loss. There are two elements that must be at least estimatable, if not formally calculable: the probability of loss, and the attendant cost. Probability of loss is generally an empirical exercise, while cost has more to do with the ability of a reasonable person in possession of a copy of the insurance policy and a proof of loss associated with a claim presented under that policy to make a reasonably definite and objective evaluation of the amount of the loss recoverable as a result of the claim.
Limited risk of catastrophically large losses. The essential risk is often aggregation. If the same event can cause losses to numerous policyholders of the same insurer, the ability of that insurer to issue policies becomes constrained, not by factors surrounding the individual characteristics of a given policyholder, but by the factors surrounding the sum of all policyholders so exposed. Typically, insurers prefer to limit their exposure to a loss from a single event to some small portion of their capital base, on the order of 5%. Where the loss can be aggregated, or an individual policy could produce exceptionally large claims, the capital constraint will restrict an insurers appetite for additional policyholders. The classic example is earthquake insurance, where the ability of an underwriter to issue a new policy depends on the number and size of the policies that it has already underwritten. Wind insurance in hurricane zones, particularly along coast lines, is another example of this phenomenon. In extreme cases, the aggregation can effect the entire industry, since the combined capital of insurers and reinsurers can be small compared to the needs of potential policyholders in areas exposed to aggregation risk. In commercial fire insurance it is possible to find single properties whose total exposed value is well in excess of any individual insurer’s capital constraint. Such properties are generally shared among several insurers, or are insured by a single insurer who syndicates the risk into the reinsurance market.
[edit] Indemnification
An entity seeking to transfer risk (an individual, corporation, or association of any type, etc.) becomes the 'insured' party once risk is assumed by an 'insurer', the insuring party, by means of a contract, called an insurance 'policy'. Generally, an insurance contract includes, at a minimum, the following elements: the parties (the insurer, the insured, the beneficiaries), the premium, the period of coverage, the particular loss event covered, the amount of coverage (i.e., the amount to be paid to the insured or beneficiary in the event of a loss), and exclusions (events not covered). An insured is thus said to be "indemnified" against the loss events covered in the policy.
When insured parties experience a loss for a specified peril, the coverage entitles the policyholder to make a 'claim' against the insurer for the covered amount of loss as specified by the policy. The fee paid by the insured to the insurer for assuming the risk is called the 'premium'. Insurance premiums from many insureds are used to fund accounts reserved for later payment of claims—in theory for a relatively few claimants—and for overhead costs. So long as an insurer maintains adequate funds set aside for anticipated losses (i.e., reserves), the remaining margin is an insurer's profit.
[edit] When is a Policy Really Insurance?
“Insurance provides indemnification against loss or liability from specified events and circumstances that may occur or be discovered during a specified period. ”
-- FASB Statement of Financial Accounting Standards No. 113, “Accounting for Reinsurance of Short-Duration and Long-Duration Contracts” December 1992
An operational definition of insurance is that it is
the benefit provided by a particular kind of indemnity contract, called an insurance policy;
that is issued by one of several kinds of legal entities (stock company, mutual company, reciprocal, or Lloyds organization, for example), any of which may be called an insurer;
in which the insurer promises to pay on behalf of or to indemnify another party, called a policyholder or insured;
that protects the insured against loss caused by those perils subject to the indemnity in exchange for consideration known as an insurance premium.
In recent years this kind of operational definition proved inadequate as a result of contracts that had the form but not the substance of insurance. The essence of insurance is the transfer of risk from the insured to one or more insurers. How much risk a contract actually transfers proved to be at the heart of the controversy.
This issue arose most clearly in reinsurance, where the use of Financial Reinsurance to reengineer insurer balance sheets under US GAAP became fashionable during the 1980s. The accounting profession raised serious concerns about the use of reinsurance in which little if any actual risk was transferred, and went on to address the issue in FAS 113, cited above. While on its face, FAS 113 is limited to accounting for reinsurance transactions, the guidance it contains is generally conceded to be equally applicable to US GAAP accounting for insurance transactions executed by commericial enterprises.
[edit] Does the Contract Contain Adequate Risk Transfer?
FAS 113 contains two tests, called the '9a and 9b tests,' that collectively require that a contract create a reasonable chance of a significant loss to the underwriter for it to be considered insurance.
9. Indemnification of the ceding enterprise against loss or liability relating to insurance risk in reinsurance of short-duration contracts requires both of the following, unless the condition in paragraph 11 is met:
a. The reinsurer assumes significant insurance risk under the reinsured portions of the underlying insurance contracts.
b. It is reasonably possible that the reinsurer may realize a significant loss from the transaction.
Paragraph 10 of FAS 113 makes clear that the 9a and 9b tests are based on comparing the present value of all costs to the PV of all income streams. FAS gives no guidance on the choice of a discount rate on which to base such a calculation, other than to say that all outcomes tested should use the same rate.
Statement of Statutory Accounting Principles ("SSAP") 62, issued by the National Association of Insurance Commissioners, applies to so-called 'statutory accounting' - the accounting for insurance enterprises to conform with regulation. Paragraph 12 of SSAP 62 is nearly identical to the FAS 113 test, while paragraph 14, which is otherwise very similar to paragraph 10 of FAS 113, additionally contains a justification for the use of a single fixed rate for discounting purposes. The choice of an "reasonable and appropriate" discount rate is left as a matter of judgement.
[edit] Is There a Brightline Test?
Neither FAS 113 nor SAP 62 defines the terms "reasonable" or "significant." Ideally, one would like to be able to substitute values for both terms. It would be much simpler if one could apply a test of an X% chance of a loss of Y% or greater. Such tests have been proposed, including one famously attributed to an SEC official who is said to have opined in an after lunch talk that a 10% chance of a 10% loss was sufficient to establish both reasonableness and significance. Indeed, many insurers and reinsurers still apply this "10/10" test as a benchmark for risk transfer testing.
It should be obvious that an attempt to use any numerical rule such as the 10/10 test will quickly run into problems. Suppose a contract has a 1% chance of a 10,000% loss? It should be reasonably self-evident that such a contract is insurance, but it fails one half of the 10/10 test. It does not appear that any "brightline" test of reasonableness nor signifance can be constructed.
Excess of loss contracts, like those commonly used for umbrella and general liability insurance, or to insure against property losses, will typically have a low ratio of premium paid to maximum loss recoverable. This ratio (expressed as a percentage), commonly called the "rate on line" for historical reasons related to underwriting practices at Lloyds of London, will typically be low for contracts that contain reasonably self-evident risk transfer. As the ratio increases to approximate the present value of the limit of coverage, self-evidence decreases and disappears.
Contracts with low rates on line may survive modest features that limit the amount of risk transferred. As rates on line increase, such risk limiting features become increasingly important.
[edit] "Safe Harbor Exemptions"
The analysis of reasonableness and signifiance is an estimate of the probability of different gain or loss outcomes under different loss scenarios. It takes time and resources to perform the analysis, which constitutes a burden without value where risk transfer is reasonably self-evident.
Guidance exists for insurers and reinsurers, whose CEO's and CFO's attest annually as to the reinsurance agreements their firms undertake. The American Academy of Actuaries, for instance, identifies three categories of contract as outside the requirement of attestation:
Inactive contracts. If there are no premiums due nor losses payable, and the insurer is not taking any credit for the reinsurance, determining risk transfer is irrelevant.
Pre-1994 contracts. The attestation requirement only applies to contracts that were entered into, renewed or amended on or after 1 January 1994. Prior contracts need not be analyzed.
Where risk transfer is "reasonably self-evident."
"Risk transfer is reasonably self-evident in most traditional per-risk or per-occurrence excess of loss reinsurance contracts. For these contracts, a predetermined amount of premium is paid and the reinsurer assumes nearly all or all of the potential variablility in the underlying losses, and it is evident from reading the basic terms of the contract that the reinsurer can incur a significant loss. In many cases, there is no aggregate limit on the reinsurer's loss. The existence of certain experience-based contract terms, such as experience accounts, profit commissions, and additional premiums, generally reduce the amount of risk transfer and make it less likely that risk transfer is reaonably self-evident."
- "Reinsurance Attestation Supplement 20-1: Risk Transfer Testing Practice Note," American Academy of Actuaries, November 2005. ...
[edit] Risk Limiting Features
An insurance policy should not contain provisions that allow one side or the other to unilaterally void the contract in exchange for benefit. Provisions that void the contract for failure to perform or for fraud or material misrepresentation are ordinary and acceptable.
The policy should have a term of not more than about three years. This is not a hard and fast rule. Contracts of over five years duration are classified as ‘long-term,’ which can impact the accounting treatment, and can obviously introduce the possibility that over the entire term of the contract, no actual risk will transfer. The coverage provided by the contract need not cease at the end of the term (e.g., the contract can cover occurrences as opposed to claims made or claims paid).
The contract should be considered to include any other agreements, written or oral, that confer rights, create obligations, or create benefits on the part of either or both parties. Ideally, the contract should contain an ‘Entire Agreement’ clause that assures there are no undisclosed written or oral side agreements that confer rights, create obligations, or create benefits on the part of either or both parties. If such rights, obligations or benefits exist, they must be factored into the tests of reasonableness and significance.
The contract should not contain arbitrary limitations on timing of payments. Provisions that assure both parties of time to properly present and consider claims are acceptable provided they are commercially reasonable and customary.
Provisions that expressly create actual or notional accounts that accrue actual or notional interest suggest that the contract contains, in fact, a deposit.
Provisions for additional or return premium do not, in and of themselves, render a contract something other than insurance. However, it should be unlikely that either a return or additional premium provision be triggered, and neither party should have discretion regarding the timing of such triggering.
All of the events that would give rise to claims under the contract cannot have materialized prior to the inception of the contract. If this "all events" test is not met, then the contract is considered to be a retroactive contract, for which the accounting treatment becomes complex.
[edit] Insurer’s business model
Profit = earned premium + investment income - incurred loss - underwriting expenses.
Insurers make money in two ways: (1) through underwriting, the process by which insurers select the risks to insure and decide how much in premiums to charge for accepting those risks and (2) by investing the premiums they collect from insureds.
The most difficult aspect of the insurance business is the underwriting of policies. Using a wide assortment of data, insurers predict the likelihood that a claim will be made against their policies and price products accordingly. To this end, insurers use actuarial science to quantify the risks they are willing to assume and the premium they will charge to assume them. Data is analyzed to fairly accurately project the rate of future claims based on a given risk. Actuarial science uses statistics and probability to analyze the risks associated with the range of perils covered, and these scientific principles are used to determine an insurer's overall exposure. Upon termination of a given policy, the amount of premium collected and the investment gains thereon minus the amount paid out in claims is the insurer's underwriting profit on that policy. Of course, from the insurer's perspective, some policies are winners (i.e., the insurer pays out less in claims and expenses than it receives in premiums and investment income) and some are losers (i.e., the insurer pays out more in claims and expenses than it receives in premiums and investment income).
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