INSURANCE BASICS FOR EVERYBODY
A really good place to start in understanding the basics of insurance (we’ll get into the more complicated stuff in later articles) is that an insurance policy is a contract. It is similar to other contracts that you’ve entered in your lifetime — like when you’ve hired a company to fix your roof or financed a car through your bank. In those cases, you expected that the repairs would be done as promised and the person who did the work expected to be paid on time. When you bought the car and were approved for the loan, you expected the bank to issue the check that it promised and the bank expected you to pay back the loan over time.
An insurance policy is similar in many respects, subject to some big differences. One of the differences is that the language and pricing of an insurance policy are highly regulated by the government. Currently, insurance is mainly regulated by the states in which the insurance company does business and that has been so for decades.
When an insurance company wants to conduct business (sell policies to insure people or things) in a state it has to apply to the state’s insurance regulator for permission to do so. State insurance laws differ so not all insurance companies choose to do business in all states. Even if an insurance company does operate in multiple states, the language of the policy might have to be different to comply with the requirements of that state’s law. That’s especially true as to insurance covering people (so-called “personal lines” like life and health insurance). Many commercial insurance policies (like those covering businesses) are standardized, so there isn’t as much variation by state.
Government regulation of insurance contracts differs from other kinds of contracts in another way, too. With most non-insurance contracts people can agree to nearly anything they want as long as the subject-matter matter is not illegal or fraudulent. But insurance contracts (policies) are closely regulated both in terms of the language of the contract and the amount of money that is charged for the insurance protection. The strict regulation is because the nature of the transaction is complex and because the insurer has great economic strength. Especially in the case of personal lines insurance, the consumer who wants to buy insurance doesn’t have input into the terms of the policy; all the consumer can really do is to do business with another insurance company — but even then, that insurer has written the policy. Therefore, the insurance regulator is there to level the playing field to do its best to make sure that the language of the policy is fundamentally fair and complies with the law.
A very important element of insurance regulation is to make sure that insurance companies have enough money to pay expected claims. That is called “solvency.” It doesn’t mean that the government gives money to the insurer; it means that the insurance regulator controls the “rates” that an insurer can charge. Through a complex mathematical formula, the “premium” that a consumer pays for insurance derives from the “rate” that the regulator approves. Briefly, a “rate” is the cost of a unit of insurance coverage (say, $100 of coverage). It is calculated by considering claims that the insurer expects to have to pay in the coming year, reasonable overhead, a margin for a reasonable profit, and other elements.
While everybody complains that insurance premiums are too expensive, an insurance company has to charge enough so that it will have enough money to pay claims that are made over a given period of time. Otherwise, it will be unable to pay claims, which defeats the purpose of getting insurance. Among the factors that an insurance regulator considers in assessing the proposed rate is that the insurer is not incorporating excessive overhead or profit into its calculations; if it does, the regulator can disapprove the proposed rate. If that happens, the insurance company and the regulator can compromise or fight about it through “administrative” litigation.
In all events, it is important to keep in mind that an insurance company is entitled to earn a reasonable profit for the risk that it takes for assuming everybody else’s risk of loss. If it can’t, it may stop issuing insurance in that jurisdiction. If that happens, the insurance market will be said to have “tightened” or become “hard”, there will be less availability and choice, and consumers may end up being the losers.