INSURANCE RUMINATIONS—WHAT IS INSURANCE?

Although we may intuitively think we know what insurance is, it may be useful to formally define it and to explain its components.  In this section, we discuss private insurance, rather than government benefits, which may bear a remote similarity.

At its core, insurance is a contract.  As such, it is fundamentally like other kinds of contracts, but with some important differences.  Perhaps the prime difference is that the content of insurance contracts is highly regulated by government, and the operation of insurers are also highly regulated by government.  Currently, most insurance regulation is on the state level, and that has been the case for many decades.  There is a move to get the federal government increasingly involved in insurance regulation, but we will discuss that later.

Government regulation of insurance contracts contrasts with many other kinds of commercial and personal contracts.  In the latter kinds of transactions, for the most part, the parties may agree to terms as they wish, provided no fraud is involved.  One of the theories behind greater government regulation of insurance is that, because insurance contracts are so complex, and insurers wield substantially more bargaining power than consumers, government is needed to protect the consumer. 

Fundamental to the concept of insurance is the idea of “transfer of risk”.  This is sometimes referred to as “indemnification” and is the essence of any insurance contract.  If we think about insurance in those terms, the insurance contract transfers the risk of loss from the insured (you) to the insurer for a specific range of losses stated in the policy.  The monetary price paid to the insurer for accepting those risks is called the “premium”.  The amount of the premium depends upon a variety of factors, including the scope and amount of benefits provided by the insurance policy, the age of the proposed insured(s), their health histories, and the insurance company issuing the policy.

 As you can see, an insurer is, by its nature, a risk-bearing entity because it assumes the financial risk of loss that would otherwise be the responsibility of the insured.  There exist other kinds of risk-bearing entities that are not, strictly speaking, insurers, but which do have some similarities.  Notable among these are managed care entities, such as health maintenance organizations (HMO's).  They operate somewhat differently than indemnity-type insurers, and will be the subject of their own article, so stay tuned.

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