Contracts transferring risk have been in existence since at least the time of ancient Babylon. The growth of a large-scale insurance industry dedicated to regularizing and facilitating transactions dates, however, from the growth of transoceanic shipping in the seventeenth century as well as the growth of mathematical and computational sophistication needed to support mass transfers of risk. The industry has grown to one of the world’s largest and in the twenty-first century comprises a ubiquitous and central component of life in developed nations, with written premiums surpassing $3.4 trillion in 2005.
Insurance—as a contract that often overcomes impediments to trade created by risk and that, of necessity, often requires significant agglomerations of corporate wealth—has long been an instrument of social success and social disgrace. It has unquestionably permitted the development of modern capitalism by stabilizing large concentrations of property or, in the case of life insurance, the preservation of family wealth with reduced regard for the longevity of particular family members. On the other hand, it was critical to the development of industrial-era slavery by permitting those involved in human trafficking to diversify the significant risks involved. It has often fueled and ameliorated the planet’s environmental woes by permitting various industries to thrive notwithstanding the oft-materializing risk of environmental harm they create, though it has also provided a major source of capital from which those injuries can be at least partly redressed. It has increased safety in fields such as fire prevention, building codes, and vehicle safety by providing a relatively centralized repository of information on risk and significant motivation for its reduction. And it has unquestionably transformed the legal system in many jurisdictions by providing otherwise unavailable large sources of wealth to vindicate rights formally created by those jurisdictions.
The modern insurance industry is divided into three parts: (1) a life and health insurance segment; (2) a property/casualty segment; and (3) a financial management segment involving reinsurance and various forms of excess insurance. While many companies engage in all parts of the industry, often through various subsidiaries, others specialize in only segments and subsegments of the market consistent with their skills in marketing, assessing risks, processing claims, and coping with regulatory impediments. The life and health industry generally assesses the health trajectories of prospective insureds. Private health insurance is used in the United States to defray the significant cost of medicine and is often (though decreasingly) offered by employers as a tax-advantaged prerequisite. It also frequently serves there as a buying agent, negotiating in advance for lower prices for medical services on behalf of its insureds. In nations with broader government-provided health care, health insurance nonetheless often functions as a supplemental vehicle for transferring the risk associated with procedures the government plan does not cover or as to which government-provided care is thought inadequate. Life insurance offers payment to reduce the risk of premature death or, in the case of annuities, offers a stream of income to offset the risk of living longer than expected. It also frequently permits a tax-advantaged form of investment.
The property and casualty insurance insures individuals and businesses from direct and indirect losses due to fire, various forms of natural disaster, and other “perils.” Casualty insurance transfers the risk of the insured encountering various legal obligations, such as an obligation to pay damages in a lawsuit or to perform on a contract. Major forms of casualty insurance include liability insurance, suretyships, and marine insurance. Large segments of the legal services industry assist casualty insurers in defense of claims against their insureds.
Much of the modern insurance contract represents an effort to address four economic challenges inherent in virtually any attempt to transfer risk. Reducing this process into words often makes many insurance contracts extremely complex and forbidding documents, as insurers use various shorthands and jargon to compress complex concepts. The first challenge, moral hazard, is the proclivity of people with insurance to increase the level of insured risk they encounter beyond what otherwise would be the case. Insurers control moral hazard through such means as making the insurance incomplete through deductibles that reduce by a fixed or formula amount an insurer’s otherwise obligation to pay a claim. The insurer likewise controls moral hazard through various exclusions and conditions that limit its obligations unless the insured adheres to various behavioral norms thought to reduce risk. These control mechanisms may make contract administration more costly, however, and can lead to dispute when the provisions involved are ambiguous or surprising to the insured.
The second challenge, adverse selection, is the proclivity of insureds that accurately perceive themselves as having a higher risk of loss than would be imagined by the insurer to purchase insurance disproportionately. Insurers attempt to curb adverse selection through tighter “underwriting,” the examination of prospective insureds before contract formation is complete, through insistence on legal systems that condition the insurer’s payment obligations on various forms of information transfer from insured to insurer, and through conditions and exclusions that prevent risk transfer in situations where the information needed by the insurer or the proper interpretation of that information would prove too costly for the particular insurer. Adverse selection potentially poses great hazards to the insurance industry, particularly where prospective insureds harbor secret information about their own level of risk. Various insurance systems have entered “death spirals” when they were unable to control adverse selection.
A third issue is that of systematic risk. Insurance works best when the risks are independent of one another and insurers can thus depend on the unbreakable “law of large numbers” to assure their profitability. When insurers encounter correlated risks, such as those posed when insuring a large number of homes in an area of seismic activity or hurricane risk or, potentially, terrorism risk, they thus either enter the market only with great caution or deploy various risk spreading and aggregation mechanisms such as reinsurance or catastrophe bonds that reduce systematic risk. These mechanisms are capable of succeeding because, while the risk that a home in the vicinity of one volcano will be destroyed from an eruption is correlated with destruction to a neighboring home, an insurance system that pooled both of their risks with those of homeowners near other seismically uncorrelated volcanoes would effectively create somewhat larger but still uncorrelated risks as to which the law of large numbers would more closely apply. The increased globalization of the insurance industry, coupled with the growth of institutions such as reinsurance, has greatly assisted with this problem.
Finally, there is simply the matter of insurers keeping their promises. Particularly in cases of life insurance or various “toxic tort” claims such as asbestosis or other environmental harms, the time between payment of premium and an insurer’s obligation to pay on a claim may span decades. Moreover, individual policyholders or smaller businesses are often at a severe disadvantage in resolving disputes with large, sophisticated, and experienced insurers and generally have difficulty banding together to attain their common interests. Insurers thus must be forced by governments to be particularly prudent with their investments and to be responsible in the way they handle claims. Doctrines such as “contra proferentem,” “reasonable expectations,” “good faith,” and “intelligibility” often play significant roles in this latter effort, though the greater ability to provide information in the modern age may result in a larger role for regulation via ratings and reputation.
Critical to the operation of the insurance industry are various intermediaries who bridge information gaps between consumer and insurer. Agents, who may work for insurers or groups of insurers, attempt to fit existing insurance products to the needs of potential insurance consumers. Brokers, or independents as they are sometimes called, serve as expert shoppers, assisting businesses of varying sophistication in the purchase of complex and often coordinated packages of insurance products. These intermediaries often permit prospective insureds to access insurance products offered by insurers in other states or nations that would otherwise be unavailable. Often, the law imposes on these intermediaries duties of diligence in assessing the fit between the insured’s needs and the products offered, the solvency of a proposed insurer, and in accurately transmitting information related to the risk posed by the insured.
Insurance tends to be a highly regulated industry. This is so in part because insurers have tremendous powers over the lives and fortunes of the individuals and businesses they insure (or refuse to insure) and in part because of their close resemblance to other large financial service industry players such as banks, whose ability to fulfill promises in times of need serves a vital social purpose. Because of the ability of insureds to cancel their insurance in most circumstances without severe financial penalty or to decline to renew their policies at relatively frequent intervals, insurance companies, like banks and other financial institutions, can lose capital rapidly. This fact means that even hints of trouble can precipitate a financial collapse with attendant financial and social ripples. Traditional insurance regulation attempts to reduce this risk through various forms of auditing, investment controls, government-sponsored backstop insurance and mechanisms to facilitate quiet recapitalization or merger of troubled insurers. In common law nations such as the United States and Commonwealth nations, courts have also been extremely important and influential in regulating insurers through the development of precedents regarding contract formation and interpretation.
In the United States, insurance regulation is conducted largely at the state level as a result of the 1868 decision of Paul v. Virginia and the substantial reconfirmation of that decision through the 1946 McCarran-Ferguson Act. There has, however, been an increasing role for the federal government, particularly in health insurance and, to a perhaps growing extent, in providing a backstop for insurance against terrorism. The McCarran-Ferguson Act generally displaces federal law regulating insurance, at least when a state is vigorously regulating the same subject, and specifically displaces most federal competition (antitrust) laws. The weakened role of competition law is said to foster healthy exchanges of information amongst insurers regarding risk and, on occasion, to regularize pricing in ways different than which would be achieved through competition.
In Europe, insurance is likewise subject to dual control, at the traditional national level and, increasingly since 1973, through directives from the European Community. Integration of these often disparate bodies of law and the various cultures and norms of these markets has been a significant challenge of the recent decades.
The insurance industry faces new challenges in the years ahead. The industry will need to penetrate developing economic markets and adapt to local risks, regulation, and customs. As technology increases the ability to predict the future, risk pools may become more heterogeneous than they are presently perceived. Thus, unless long range contracting can be accomplished prior to the time prediction proves possible, or unless governments intervene with compulsory pooling mechanisms, insurance may become more difficult and more expensive for some groups to attain. Insurers will likely be called on to take heightened responsibility for the discrimination they foster through various rating practices that depend sometimes on accurate if unflattering information and sometimes on informational proxies that may neither be fair nor particularly accurate. Privacy issues likewise will concern the insurance industry. As large aggregators of data, insurers will come under increasing pressure to develop codes of conduct relating to the assimilation and dissemination of information. Cultural or religious barriers to insurance are likely to come under pressure as various segments of the globe develop more mature forms of capitalism; and, indeed, the growth of “takaful,” mutual insurance that complies with Islamic limitations on purchase of commercial insurance, are symptoms of both this adaptation and expansion of the insurance industry. Finally, the industry will likely wish to develop mechanisms for handling new risks. Global climate change potentially poses significant risk to the insurance industry, which may grow in its advocacy for measures designed to reduce the impact of adverse weather conditions.
SEE ALSO Adverse Selection; Global Warming; Industry; Moral Hazard; Risk; Slavery; Uncertainty
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Seth J. Chandler