Not Instant Money

Examples of Non-Insurance Financial Transfers

Surety Bonds
A surety bond is a three parties contract between: (1) the principal which obtains the bond and pays the premium, (2) the oblige which is the beneficiary of the bond, and (3) the surety company, generally an insurance company, which guarantees the obligation of the principal towards the oblige.
Under a surety bond, the loss faced by the oblige may be caused intentionally or not by the principal. In practice, a no loss situation is expected otherwise the insurance company would not grant the bond. The premium covers only the surety's investigation costs, the transaction costs, and a margin for profit for the company. If a loss does occur, the surety company can turn to the principal for reimbursement. A surety bond is not an insurance contract.

Contracts of Sale, Supply, and Services

Contracts relating to the distribution of goods and services also provide transfer of risk. Producers and distributors often offer to their costumers some guarantees against defects of products. Examples are the warranties offered by the seller and the manufacturer on the performance of a car (new or used) or service contracts on computers, television, home equipment, etc.

When a firm enters into an arrangement to lease equipment or facilities for its own use, the contract usually stipulates that the provider must bear the burden of any damage to, or destruction of the property. The transfer may include responsibility regardless of the cause of the damage, and also legal responsibility for all legal liabilities arising out of the use of the equipment or facilities. As in the case of transfers regarding damage to, or destruction of property, the transfer may be conditioned upon the circumstances giving rise to the liability.

Hedging is based upon the assumption that in efficient money or commodities markets the present cash value and the future price will move in the same direction. Any gain or loss in a cash position today, due to an unforeseen circumstance, will be offset by an equal gain or loss from the future position. If the price of a commodity (or a currency) should drop today, there will be a loss

on a cash position compensated by a corresponding gain in the future (short-term or long-term ) position. Hedging with future contracts or forward contracts is a very useful and worldwide practice in many forms of trade. Another interesting application of hedging are the put and call options in stock markets.

Financial Leverage
The limited liability of the corporate form of organization could be consider as a form of risk transfer. Loss in excess of business assets is borne by the creditors rather than by the owners. The issue of capital structure is probably one of the most studied and debated in all finance. If the firm is heavily leveraged, the limited liability of shareholders means that bondholders must bear most of the risk while shareholders gather most of the potential returns.

According to the Black-Scholes option pricing model, this option becomes more valuable as company cash flows increase in variability. The result is a transfer of wealth from bondholders to shareholders because the risk of default has risen but bondholders are not compensated for the added risk. Shareholders, other things being equal, have an incentive to engage in risk-increasing activities (highly risky projects) that have the potential of high returns.

Suggestion for Additional Reading in Insurance

Williams C.A. and R.M. Heins, Risk Management and Insurance ,
New York: McGraw-Hill Book Co., 6th ed., 1989, Chap 12, 15 & 16.
Borch, Karl, Economics of Insurance , Amsterdam: North-Holland, 1990.
Brown, A., Hazard Unlimited. The Story of Lloyd's of London, London: Peter Davies Ltd., 1973.
Greene, Mark R. and J. S. Trieschmann, Risk and Insurance, Cincinnati, Ohio: South-Western Pub. Co., 7th ed., 1988.
Keeton, Robert E., Insurance Law: Basic Text , St. Paul, Minnesota:
West Publishing Co., 1971.
Mehr, R.I. and B.A. Hedges, Risk Management: Concepts and Applications ,
Homewood, Illinois: R.D. Irwin, Inc., 1974.
Pfeffer, Irving, Insurance and Economic Theory , Homewood, Illinois,
R.D. Irwin, Inc., 1956.
Picard, M. and A. Besson, Traité général des assurance terrestres en droit français,
Paris: LGDJ, 5th ed., 1977.
Williams, C.A., Head, G.L., Horn, R.C. and G.W. Glendenning, Principles of Risk Management and Insurance , Malvern, Pennsylvania: American Institute for Property and Liability Underwriters, 2nd ed., 1981

Institutional Constraints to Insurance

Some important institutional constraints on the existence or availability of insurance contracts come from law, custom, and the organization of the insurance market. They usually differ in different countries according to the political or economical environment.11

Regulatory Constraints

Regulations affect the availability of insurance with regards to the type of coverage that can be written and the type of institution that can write insurance contracts. For example, in most countries, insurance companies are forced by law to specialize in property and liability insurance or in life insurance. In the early years of insurance, each line of business had to be approved separately. From this point of view, the American regulatory tradition has been more restrictive than the British regulatory tradition. The traditions persist, even when traditionally separate lines of insurance are provided by a single company, the traditional divisions and wording of coverage exist.
Risks Insurable by Governments Only

Where the government is itself in the insurance business, it uses political means to protect its market position or to prohibit the writing of insurance contracts for certain types of coverage. For example, health insurance is part of the Social Security system of many European countries and is operated by the State.

Market Organization

Almost all countries require by law that insurance on local insurable interest be purchased in locally licensed companies. There is of course a conflicting situation when the economic agent is located at a different place than the insurable interest (this is typically the case in marine insurance).
Some laws and regulations specifically prohibit the licensing of insurers or insurance operations of particular types. Whether these particular regulations have the effect of producing a shortage of insurance depends on a variety of factors. Market imperfections may also exist concerning the availability of some types of coverages because of the limited size of the market, the small size of the companies, or the lack of expertise and know-how.

Standardization and Structure of Contracts

The terms of an insurance contract are embodied in a written document called the insurance policy. Policy forms vary in complexity depending upon the type of insurance coverage but a certain degree of standardization exists and these standards are very similar from one country to another. Also, a certain degree of uniformity exists and is essential in the presentation (the structure) of insurance policies (Table 8.3).

The terminology used is peculiar to insurance but the declarations, insuring agreement, definitions, exclusions, and conditions are the essential parts of all insurance policies. In addition to the basic policy form, an insurance policy frequently contains several attached forms, riders, or endorsements modifying the coverage.

Table 8.3
Typical Structure of an Insurance Contract
Declaration: Identification of the insured and coverage.
Insuring Agreements: Characteristics of coverages and agreement
between the insured and the insurer.
Definitions: Definition of all important words ( events, perils,
persons, location, losses, time period).
Exclusions: Limits of the coverage and identification of
perils, people, property or time not covered.
Conditions: Rights and obligations of the insured and
the insurer under the contract.

The Characteristics of Insurance Contracts

Legal Aspects

Insurance contracts, in all countries, are subject not only to the same basic law that governs all types of contracts, but also to some legal principles that have been developed to handle the legal problems associated with insurance and summarized in Table 8.2 .9,10

In order for a contract to be legally valid there must be (1) an agreement between the two parties (usually refer to "offer and acceptance"), (2) a valuable consideration, and (3) legal capacity and purpose. Beyond the necessary contractual conditions, certain elements are peculiar to the insurance policy. Generally the policy is unilateral and only the insurer is obligated to act. It is also a conditional and aleatory contract.

As a contract of "utmost good faith," (uberrimae fidei) a certain degree of honesty is presumed from both parties. This principle imposes a higher standard of honesty on the two parties than is usually expected in ordinary commercial contracts. To avoid a contract, a warranty (a statement contained in the contract and which requires that a particular condition exists) must be false, a representation (a statement made by the insured to the insurer on which the latter relies to price the contract) must be false and materially important, and concealment made with intent to deceive (the insured has an obligation to inform the insurer about facts that may be materially important).

Table 8.2
Legal Aspects of an Insurance Contract
A Valid Contract: - Legal purpose
                             - Legal capacity
                              - Obligations
An Insurance Contract:             - Personal contract
                                                   - Unilateral contract
                                                   - Conditional contract
                                                   - Aleatory ( Contingent) contract
                                                   - Contract of "utmost good faith"
The Concept of Insurable Interest

The Concept of Insurable Interest

Post-loss Control
The loss-adjustment process (loss adjusters) determines the amount of compensation to be paid under the contract. It is an administrative procedure requiring evidence of a loss, appraisal of the damage and the compensation to be paid by the insurer (the claim adjustment).
Moral hazard is being controlled through such measures as reporting services, claim adjustment services. In automobile insurance, in order to reduce fraud on the amount claimed, a typical example is the appointment of recognized garages by insurance companies.

The Concept of Insurable Interest
In a broad legal sense, an insurable interest is the kind of financial interest a person must possess in order to have legally enforceable insurance coverage. Section 5(2) of the Marine Insurance Act 1906 in the United Kingdom defines the insurable interest as: "In particular a person is interested in a marine adventure where he stands in any legal or equitable relation to the adventure or to any insurable property at risk therein, in consequence of which he may benefit by the safety or due arrival of insurable property, or may be prejudiced by its loss, or by the damage thereto, or by the detention thereof, or may incur liability in respect thereof."

In property insurance, a person has an insurable interest in a property whenever he may sustain direct and immediate damage by its loss or deterioration. Future property and incorporeal property may be the subject of a contract of insurance. The insurable interest need not exist at the time the insurance is purchased but must exist at the time of the loss. The insurance of a property in which the insured has no insurable interest is without effect. The approach is similar for liability coverages.

Property and liability insurance contracts are contracts of indemnity. Therefore the monetary value and definition of the coverage must be stipulated in the contract. It is also explicitly mentioned that duplicate coverage for the same insurable interest is not possible. This is evident for a property coverage to avoid multiple indemnification; the provision is different for liability coverages if different limits of coverage are specified in several contracts.

In addition to preventing the insured from collecting several times for the same loss, the insurance company has a subrogation right. After the insured has been indemnified, the insurance company is subrogated to the insured's rights of recovery from anyone causing the loss. However, the right of subrogation is not automatically accorded to insurers under every type of coverage they write. For example, in the common law, subrogation is automatically allowed for property insurance coverages but always denied to life insurers.

If there is a recognized insurable interest, a risk can be insured even if no statistics or risk analysis is possible. This is brought out by the following case reported by Brown (1973):
In 1971, the whisky distillery Cutty Sark offered an award of one million pounds for the capture of the monster assumed to live in the Loch Ness in Scotland. Cutty Sark approached Lloyd's of London about the possibilities of insuring against the eventual discovery and the financial consequence for the firm. The premium was fixed at £ 2,500 to cover the risk of the monster being captured alive between May 1, 1971 and April 30, 1972. The definition of a "monster" was the following; "As far as this insurance is concerned the Loch Ness Monster shall be deemed to be: (1) in excess of 20 feet in length, (2) acceptable as the Loch Ness Monster to the curators of the Natural History Museum, London."

In life insurance, the contract is without effect if at the time of contacting it, the policyholder has no insurable interest in the life or health of the insured. A person has an insurable interest in his own life and health and in the life and health: (a) of his consort, (b) of his descendants and of those of his consort, whatever their filiation, (c) of any person upon whom he is dependent for support or education, (d) of any person in whose life and health the insured has a pecuniary interest.
The creditor has an insurable interest in the life of the debtor that is equal to the amount of the debt and interest. Business relationships, other than that of a creditor and a debtor, can justify that an employer has an insurable interest on a key employee, a partner, a board officer. In all cases, however, the person being insured must agree to the proposed contract.

The absence of an insurable interest does not prevent the formation of the contract if the insured gives his written consent. Contrary to property and liability insurance contacts, life insurance contracts make no reference to indemnification

because the value of a human life is not defined. Therefore there is no problem of duplicate insurance. In fact there is no problem if an individual wants to buy several life insurance contracts with one or more insurance companies. For the same reason, life insurers do not posses subrogation rights.

In Health insurance, all types of medical expense coverages are contracts of indemnity and are similar to property and liability contracts. On the other hand, income replacement paid under health insurance contracts must be assimilated to a life insurance type of coverage
Insurance and Loss Control

Insurance and Loss Control

Because of the existence of indirect costs, like moral and morale hazards, generated by insurance contracts, insurers have created loss control devices or activities to offset these costs.

Pre-loss Control

Insurance is clearly limited only to pure risks although there are some examples of risks of a speculative nature that have been proposed in the recent past.7 Insurance contracts also contains limits that state the types of perils to be covered and the maximum amount of loss exposure.
The underwriting process (the underwriter) determines the eligibility of the insurance buyer, the types of risks to be covered, the amount at risk for insurance coverage and other informations affecting the insurability of the risks.

Most insurance contracts cover losses up to a stated maximum monetary amount that may differ depending upon the perils, persons, types of loss, or
locations covered. Limits may be stated as a maximum amount that is payable per occurrence, regardless of the number of occurrence, or as an aggregate limit which state the maximum amount the insurer will pay because of occurrences during the period of coverage (usually one year). However in a liability coverage many contracts do not impose a limit on the maximum possible loss. In some countries, limits on some types of liability coverage are even illegal (automobile insurance is the most common case).

A deductible is an example of insurance device that requires an insured to bear part of the potential loses covered under the contract (provisions for loss-sharing). Typically the insurer will pay only the losses exceeding a predetermined amount of money. For an individual fire insurance contract or automobile insurance contract, this amount will probably be less than 1 percent of the amount of coverage although the insured may have the choice of several deductible amounts.

For a contract covering the needs of a firm, the deductible may be much higher because the firm is willing (has the capacity) to retain a higher portion of the loss exposure. However, deductibles are often imposed by the insurer rather than selected by the insured.

Monetary deductibles are of two types. A per-occurence deductible applies to each loss. An aggregate deductible applies only up to a cumulated amount during the period of the contract (one year). Quite often the two deductibles are used together.

The deductible may require the insured to pay a fixed percentage of every loss that occurs, up to a given maximum annual amount defined in the contract (this is typically the case of health insurance contracts). The term "coinsurance" is often used (misused) to describe loss-sharing arrangements, especially in health insurance. The percentage of coverage, for example the contract will reimburse 80% of incurred losses, is usually in excess of any aggregate deductible.

In health insurance, the term "co-payment" is also used to define a fixed monetary deductible applying to each occurence in addition to the annual deductible. For example a $10 co-payment for a visit to a doctor instead of a reimbursement rate of 90%.

Besides the usual deductibles, the concept of disappearing deductible is often used for large business risks. Under a disappearing deductible, the size of the deductible decreases as the size of the loss increases. At a given level of loss (L*) the deductible is equal to zero (disappears). The formula to apply the reduction in the deductible (D) is the following:
Compensation by the insurer = ( Amount of loss - Deductible) x (1+k)
where k is the adjusting factor:
k = D / (L* - D)
and L* = D/k + D
If the adjusting factor is fixed at 5% and the deductible is $1,000, then the deductible will disappears when the loss equals or exceeds $21,000. All losses under $1,000 are absorbed by the insured. On a loss of $15,000 the insurer would pay $14,700 ( a $300 deductible).

A franchise, often used in marine insurance contracts and engineering, is a limit expressed as a percentage of value or as a monetary amount under which no compensation is paid by the insurer. The difference with a deductible is that when the loss equals or exceeds the limit (amount), the insurer must pay the entire loss without any deductible. The purpose of a franchise is to avoid smaller losses to reduce administrative expenses.

In some cases, like health insurance contracts or unemployment insurance contracts, the deductible is not only a monetary deductible but also a time deductible called a waiting period or an elimination period. Coverage for the peril, accident, injury or illness will start only after a predetermined period of time defined in days or months. It is a limitation on benefits used to limit moral hazard or eliminate duplication of coverage. From this point of view, the suicide clause under a life insurance contract may be assimilated to a time deductible.8 Similar to monetary deductibles, the longer the waiting period, the lower the premium, other things being equal.

Regardless of the form of the deductible, the obvious effect is also to make the insured more careful because he will have to pay his share of the loss. The secondary effect is that the administrative expenses faced by the insurance company to settle a claim will be reduced if there is a significant number of losses smaller than the deductible. The advantage for the insured is that the premium will be lower than for full coverage.

A coinsurance clause is another device, or clause of a contract, which protect the insurer against wrong evaluation (or declaration) by the insured of the value of the property at risk. It is often used in property damage to houses or buildings because in most cases the damage is only partial and it creates an incentive for the insurance buyer to undervaluate the coverage.
If the insured fails to carry an amount of insurance coverage at least equal to some specified percentage of the value of the property at the time of the loss, the insurer will not pay the full amount claimed. In all cases, the amount the insurer will pay is either the total loss up to the insurance coverage (eventually minus the deductible) or a lower amount determined by the following formula:
Amount of insurance coverage
_________________________________ x Loss
( Coinsurance %) x (Value at time of loss)


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