Monday, September 06, 2004

Financial Concepts - Insurance

One of the problems we face in life is uncertainty as to what the future holds. We make plans and we commit resources to projects. But we know that not all of our plans will turn out as expected and, in many cases, we know that disasters or other tragedy may intervene to spoil our plans. Insurance is not designed or intended to reward people with wealth. Rather, it is a means of compensating victims of destructive natural events and reducing or eliminating the financial loss that accompanies natural tragedies.

Modern insurance began during the sixteenth and seventeenth centuries when England and other Western European nations began expanding their foreign trade with the Orient and other distant lands. Individuals formed companies to invest in ships, crews and trade goods to be traded for spices and other prized articles not found in Europe. A successful voyage, which often took two or more years, would yield profits equal to many times the amount of the original investment. However, success was not guaranteed as many ships were lost due to storms, pirates, disease, etc. When a ship was lost the investors lost their entire investment. To prevent this, investors began banding together and forming pools in which they first estimated what percentage of ships they expected to lose and then each contributed a portion of the cost of the ships expected to be lost. The investors did not know which ships would fail to return only that, based upon past experience, a certain number of the total ships setting sail could be expected not to return. If one's ship returned the owner reaped huge profits from the sale of the goods obtained by trade. But if a ship did not return the investors in that ship could recoup the money they had invested (but not any of the profits they could have made). Through the insurance the risk of loss shifted from the individual investors to the entire group. Now when a ship was lost the individual investor lost only his contribution to the insurance pool not the entire investment. People did not make money from the insurance, instead they simply limited or eliminated their losses due to natural events.

The concept of moral hazard is an insurance term that defines the practice of structuring insurance policies so that their use is limited to protecting the financial interest of those insured from known environmental hazards. We do not want the existence of insurance to encourage behavior that leads to the losses we are insuring against. Thus, in the case of the early ships, the insurance reimbursed the owners/investors for the loss of their investment in the ship but not in the loss of the profits. This was to discourage them from turning a quick profit by running the ship aground and destroying it as it left the harbor and gaining the expected profit from the planned trade immediately rather than waiting one or more years for the trip to be completed and the goods sold before receiving their expected profit.

As the economy has become more complex and sophisticated newer types of insurance have evolved to protect people financially from natural calamities. In this article I will discuss some of the more common general types of insurance. Competitive market forces are continually driving insurance companies to develop new variations of these standard types of insurance in order to meet the evolving needs of consumers. But all types of policies have the same basic purpose and that is to protect against financial loss from known natural causes.

Property and Casualty Insurance: Property and casualty insurance is designed to protect the physical property of individuals and businesses. Things like homes, cars, boats, and other valuable property such as jewelry, art, etc. The thing being insured (protected) is the asset itself. Thus, the insurance will pay the value of the asset or the cost of repair if damage is less than 100% when the asset is destroyed or damaged due to fire, wind, flood, theft, vandalism, accidental actions of others, etc. Property and casualty insurance protects the physical property of the insured and does NOT insure damage to other people's person or property by the insured.

Liability Insurance: Accidents happen and people and/or their property suffer financial damage as a result of accidents caused by others. Under common law, a person, whose actions result in injury or damage to other persons or their property, is responsible for the cost of repairing the damage. When a person suffers injury to themselves and/or damage to their property as a result of the accidental actions of another they have a right to go to court and sue the responsible party for damages.

In times past when society was much poorer and people had fewer things accidents tended to be less frequent and less costly. But as society has become wealthier and average people began acquire more and more property, the frequency of costly accidents has increased. There is both more property to damage and more means of damaging things (think of all the automobiles on the road and the numerous opportunities for "fender bender" type accidents) in our modern society. Liability insurance is the market's response for the need to protect people from losing their assets as the result of an accident for which they are at fault.

When a person or a business is responsible for an accident that results in injury or damage to the property of another, liability insurance covers the cost of compensating for the damage or injury.

Health or Medical Insurance: Medical insurance is designed to protect people from the financial costs of treating major illness or injury. Cancer, heart attacks and other major diseases as well as injuries from accidents can result in a huge financial drain for treatment alone.

Medical insurance began as hospitalization insurance in the early part of the twentieth century. At that time the major health expense was hospitalization for a major illness or injury.

Prior to the twentieth century, about all the medical profession could do in most cases was attempt to ease the pain, set broken bones, assist with childbirth, etc. According to the U.S. Centers for Disease Control[1], average life expectancy for Americans at birth in 1900 was 47.3 years and by 2001 it had risen to 77.2 years. Modern science has eradicated or controlled most of the diseases, such as small pox, pneumonia, dyptheria, cholera, etc., which historically have been responsible for the death of large numbers of people and has also drastically reduced the number of deaths among women and newborns during childbirth. This has left things like heart disease and cancer, both of which are primarily associated with older people, as well accidents, as the major health problems in the U.S. The advances in medical science both drastically reduced the probability of being stricken by a life threatening disease and made it possible to treat and often cure disease when it does strike. For the average person, life threatening disease ceased to be a fact of life that most people would have to deal with and, instead, became a threat with a small probability of striking a specific person. Further, when a major disease does strike it is now possible to treat it, but the treatments are expensive. Thus, the need for insurance to protect one's financial security in the rather remote event that they or members of their family were stricken by a major medical problem.

If medical insurance had remained limited to covering the costs of treatment of major illness and injury it would not be the hot political topic it has become today. However, what is called medical insurance today is really a prepaid medical plan with some insurance features. Instead of being restricted to major illness and injury, today's medical plans cover nearly all medical expenses including routine doctor visits, medication, etc. Further, there is a disconnect between the consumers of medical services and those paying for medical services (the third party payer is usually the employer). Unlike most goods and services where the consumers are the ones who pay for what they consume, medical services are paid for by a third party. With medical services, the average consumer now consumes what they want or need without being concerned with the actual cost. It is the consumer's employer who bears the cost of medical services. The roots of this change from a market response to the need to protect people from being harmed financially by a major illness or accident to a system where medical care is predominantly paid for by one's employer can be found in both the government sanctioned cartel that controls medical care and in the income tax system[2].

Dental Insurance: Dental insurance is a specialized form of medical insurance that protects people against financial loss as the result of major dental work. Currently dental insurance is not very common for two reasons. First, people do not use dentists as much as other parts of the medical profession so there is not as much demand for the insurance. Second, most uses for dental insurance can be planned to some extent – people either elect to have procedures such as orthodontics (braces) or become aware of problems that will require major dental work in time to plan for the procedure. The advance planning allows the people to purchase the dental insurance in advance of the procedure and then cancel the insurance once they no longer need it. This tends to drive up the cost of the insurance which is a further incentive not to purchase it until needed.

What most people think of when dental insurance is mentioned is what are known as dental plans. These are not insurance but rather agreements between the plan sponsor and participating dentists for the dentists to give members of the plan a discount on their services. These plans are relatively inexpensive and, for a small monthly or quarterly fee, participants get a schedule of guaranteed prices that are lower than the dentist's regular prices. The dentist, in turn, gets a larger patient base as a result of working with the plan. The fact is that much dental work involves preventative measures which are easy for people to postpone. But once a person has brought a plan and receives a discount on dental services they have an incentive to visit the dentist regularly for cleanings and checkups in order to get their money's worth from purchasing the plan.

Life Insurance: The term life insurance is a misnomer because what we are actually insuring is the lost income of the individual and not that individual's life. We cannot put a value on a person's life, but we can calculate the value of the income the deceased person would have earned if he/she had lived.

Life insurance is simply a mechanism for protecting those with a financial interest in the insured from the financial loss that would result from the insured's early death. When a person dies, those who depend upon that person for financial support lose that support. Put simply, life insurance is a mechanism whereby a person can protect his/her dependents from financial loss in the event of the insured's unexpected or untimely death.

Like other types of insurance, life insurance is based upon the principle that out of a given population of individuals whose health, age range, life style, etc. are similar we know that a certain number are likely to die in a given year. By collecting money from all of them the insurance company is then in a position to pay off the survivors of the few that die.

There are two main types of life insurance, term insurance and whole life insurance. Term insurance is a simple insurance policy that, in return for a premium payment, the company agrees to pay a fixed settlement to the insured's beneficiary in the event the insured dies within the term of the policy. If the insured does not die, the coverage expires at the end of the term for which it was purchased. Whole life is a combination of term insurance and a savings plan. A person purchases a policy and the company calculates the cost of insurance for their expected remaining life. The initial premium is set higher than for normal term (the cost of insurance increases with age since the chance of dying increases with age) with the extra amount being set aside as paid up or self insurance. For example, if a 21 year old purchases a $100,000 policy, part of the annual premiums are used to purchase the $100,000 worth of insurance for the early years and the remainder is held in an account for the insured that grows over time as more premiums are paid and income is earned from investing the money. As this "cash value" builds up the need for insurance decreases. Thus, when the cash value reaches $1,000 the company only has to provide $99,000 worth of insurance for the individual since the remaining $1,000 of the $100,000 death settlement will come from the cash value of the policy. Thus, as time passes the cash value will increase as a result of savings and the cost of insurance will increase as a result of the insured getting older. However, the company is able to keep the annual premium constant since, as the cash value or self insurance increases, the amount of insurance needed to pay the $100,000 death benefit decreases.

Disability Insurance: Disability insurance protects the individual against the loss of income as a result of illness or injury that reduces or prevents the individual from working and earning a living. Most high income professionals, such as doctors, lawyers, etc. who have invested a large amount of money in training for their profession, purchase disability policies to protect their investment in their skills. Also, many companies provide disability insurance as part of their benefits package to their employees.

Disability insurance is sold in the form of both long term and short term policies. Long term disability policies generally provide benefits for the duration of the disability or retirement whichever comes first. However, long term disability policies generally have a three to six month or longer waiting period between the start of the disability and the start of benefits. Short term policies are policies that provide coverage for a three to six month period only (i.e., they cover the interval between the start of the disability and the start of benefits from a long term policy). Since the disability period for many accidents/illnesses is relatively short, the cost of paying disability claims can be reduced substantially by excluding these short term claims from the long term disability policies. Further, many people are able to use accumulated sick pay and/or savings for short term disabilities thereby avoiding the need for short term disability insurance.

Mortgage Insurance: Mortgage insurance insures a mortgage lender against default (i.e., non-payment of the loan) by the borrower. Mortgage insurance is available through private companies as well as through the Federal Government from the Federal Housing Administration (FHA) and Veterans Administration (VA). Mortgage insurance is usually required for mortgage loans in which the borrower makes little or no down payment from their own funds and borrows the entire amount (or a very high percentage) of the purchase price of the property. Not having an equity interest (i.e., a sizable portion of their own funds invested) in the property makes the borrower a higher risk since they have nothing to lose financially by not making the mortgage payments.

Mortgage insurance enables the lender to turn the loan over to the insurer and get the money they loaned back when it becomes apparent that the borrower is no longer willing or able to make the payments. The mortgage insurer then bears the costs of foreclosing and taking the risk that they may not be able to recover the full value of the loan from the sale of the property.

Mortgage insurance is for the protection of the lender, not the borrower. However, except for loans insured by the Veterans Administration (VA Loans), it is the borrower who pays for the insurance. In the case of VA loans, which are only available to eligible veterans, the Federal government pays for the insurance as a part of their benefits to veterans.

Mortgage insurance should not be confused with mortgage life and disability insurance which is an option offered by most lenders. This insurance, which is optional, is a specialized form of regular term life insurance and disability insurance which either pays off the loan in the event of the borrower's death or makes the monthly loan payment when the borrower cannot work due to illness or injury.

Title Insurance: Title insurance protects a lender and/or a buyer of real estate against loss of real estate property due to a past error or past illegal transaction in the chain of title. Since ancient times, ownership of land has been backed up by documentary proof of ownership in the form of some type of deed. Deeds describe the physical location of the property and the rights that go with the property.

Problems arise when real estate is transferred illegally (i.e., the person selling the property is not the legal owner or agent of the owner), others have competing claims (liens, easements, etc.) and these transactions are not detected until several transactions later. At this point the current owner (and lender if there is a mortgage) are innocent victims of the past actions as their interest in the property is now in doubt and must be settled in court. If the court decides against the current owner, that person loses his/her investment and the lender loses the property that is backing up the loan.

Title insurance companies research the chain of title to verify its validity and then issue a policy that promises to compensate the purchaser for the purchase price of the property and the lender for the loan amount of the property in the event the title insurance company misses a transaction that puts ownership in doubt. Separate policies have to be purchased for the lender and the owner and it is usually the owner or sell who pays for the one time fee for the policy (NOTE: the one time fee is good only for the current lender and owner. A sale of the property requires a new owner's policy and a new loan requires a new lender's policy).

Deposit Insurance: Deposit insurance insures owners of bank accounts against loss of their deposits in the event the bank fails and is unable to provide funds to its depositors. Today, most deposit insurance is provided by the Federal Government through the Federal Deposit Insurance Corporation. In years past private companies and some state governments offered deposit insurance as well but, since the bank failures during the Great Depression of the 1930s when the federal government began offering deposit insurance, the federal government has steadily pushed non-federal providers of insurance out of business. The insurance is paid for by banks and the insured are the depositors.

Securities Investor Protection Corporation (SIPC): This is insurance provided by the Federal government to securities firms to protect the accounts of the firm's clients in the event the firm fails. The securities firm has to join the SPIC and pay for the insurance for its clients. The client is then protected against the loss of their cash and securities held by the firm up to $500,000 (with the cash portion of the account being limited to $100,000). In addition to the insurance coverage limits there are other restrictions on what the insurance covers. Finally, the SIPC does not cover losses in value of securities due to market fluctuations .

Old Age Survivor and Disability Insurance (OASDI or Social Security): Most people associate Social Security with retirement. However, in addition to the retirement benefit, Social Security provides for monthly disability income to covered workers who are unable to work due to illness or injury. It also provides a monthly benefit for each child until age eighteen (longer if the child goes to college) to a surviving parent of young children when the covered worker dies. There is also a burial benefit which offsets part of the cost of an inexpensive funeral. OASDI is paid for by workers and their employers through a payroll tax on the worker's earnings with the worker paying half and the employer paying half.



NOTES:

1 Life expectancy data found at: http://www.cdc.gov/nchs/data/hus/tables/2003/03hus027.pdf on 8/15/04

2 See "100 Years of Medical Robbery" by Dale Steinreich, Ludwig von Mises Institute Daily Articles, June 11, 2004 http://www.mises.org/fullstory.aspx?control=1547

Copyright © 2004 by Charles J. Nugent

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