Features of Insurance

Features of Insurance

1. The transfer of risk
      distinguishes insurance from certain other financial instruments and provisions by which an enterprise deals with or manages the insurance-related exposure. This risk often attaches to risks attached to the insured subject, i.e., is a “personal” risk. IAA PAPER FEATURES OF INSURANCE CONTRACTS (IASC Insurance Issues Paper, Sub-Issue 1A, Paragraphs 17 & 25) 3 

2. Pooling of risks. 
       Two aspects of risk pooling can be distinguished: a. Contract-owner view. Due to the inability of an individual/enterprise to deal effectively with her/his own risk as to the frequency, timing and/or the severity of pertinent contingent events, pooling of reasonably homogeneous risks is needed. In this way, the individual contract-owner is able to spread her/his risk by transferring it to a pool of similar risks. b. Insurer view. The insurer has the ability to manage these risks through a number of risk management techniques, including the pooling of similar risks (usually similar in terms of the characteristics of the risk subjects, but this pooling could occur over time as well) or securitization of the risks (this has been done only in a limited set of circumstances to date). For both the contract-owner and the insurer, this pooling of risks is beneficial and overall both obtain the benefits of this pooling when the contract is continued. 

3. Guarantees of a long-term nature,
      including guaranteed insurability, exist in many insurance contracts, regarding such contract elements such as minimum credited interest rates, maximum premiums, and maximum expense, surrender, or mortality charges. Guaranteed insurability results from the valuable benefits associated with being a member of an insurance pool. The costs to the insurer may not be level during the period of the contract, in many cases resulting in a savings element that is inextricably combined with the pure risk element.

 4. A bundle of real and financial options that can be quite complicated and difficult to separate, 
    available to both the contract-owner and the insurer. These consist of rights provided under the contract, including the right to pay premiums and the risks of cancellation, non-renewal, lapse, use of paid-up options. There are also a number of near-rights that may be considered. For example, in many insurance contracts, even though the right of termination may exist at expiry of the current contract term, a high percentage of contracts are continued through renewal. This complexity that otherwise would result in higher transaction costs, can be reduced as a result of bundling them together in a single contract.

 5. Entry and re-entry restrictions may be continued in an insurance contract.
      Because of the potential for anti-selection (moral hazard), criteria are often developed (generally in addition to the credit risk of the contract-holder) to minimize the associated additional costs. For example, if an insurance contract is terminated, the acquisition of a replacement contract may require new underwriting.

 6. A continuous option to terminate the contract, 
      although it may be restricted as to who can terminate it and when it can be terminated. This may consist of a continuous series of renewal options available at specified dates. A near-right that is included with many contracts at their expiry is that they will usually be automatically IAA PAPER FEATURES OF INSURANCE CONTRACTS (IASC Insurance Issues Paper, Sub-Issue 1A, Paragraphs 17 & 25) 4 continued, usually with the same premium structure but sometimes at a different premium level sometimes restricted as a result of contract or regulatory rules. 

7. The purchase of an insurance contract
       is generally made under the perception that the insurer will fulfill certain promises or implied promises of certain insurance contracts, often referred to as policyholder expectations. These expectations, often long-term in duration, are supported by the regulation of the insurance industry in the public interest. Some of these expectations include the equitable treatment with respect to participation in the profits generated by participating (with-profits) contracts and other non-guaranteed elements and the continuation of a customer relationship with respect to the exposures being insured. 

8. The insurer may be constrained to utilize 
     certain of its options on the basis of a class of insureds, rather than the individual insured. These constraints may be imposed as a result of the nature of the law or regulation affecting such contracts. 

9. Certain aspects of both insurance contracts and insurance companies are highly regulated,
      due to the perceived public interest inherent in the contracts, resulting from the long-term guarantees of the contracts, the imbalance in information regarding the nature of insurance, and the imbalance of control over the implementation of certain contract provisions between the contract-owner and the insurer. 

10. The probabilities of the utilization 
       of these options and the cost associated with them are considered in determination of both entry and exit prices as viewed by the insurer. The reasons why insurers enter into these contracts include an expected reward for risk undertaken and opportunities for profit related to these risks. In order to quantify them, probabilities relating to the expected frequency, amount and timing of the associated cash flows are considered, as well as the uncertainty and volatility associated with these cash flows.