Principles of Insurance – UCONN Law – Prof. Jill Anderson Spring 2012
A. Risk: a risk is something that can happen… insurance usually only addresses the downside of risk. 2 complementary usages:
1. a person, property, or enterprise is insured, and
2. the possibility that something can harm that person, property, or enterprise
B. Risk Transfer: a transaction or institutional arrangement that transfers, or shifts, risk from one person or entity to another
C. Risk Spreading: occurs whenever an entity takes on risk and parcels it out to a group of people… insurance is the paradigmatic risk-spreading institution (unique in that way)
1. Example: many people pay relatively small amts. of money so that there is a large pot of money to cover the costs of an unfortunate few who suffer a loss
a) families, product liability laws, employment agreements, and corporations all spread risk
D. Risk Aversion: name given to the nearly universal preference for certainty over uncertainty with regard to future losses
1. helps explain why someone pays an insurance premium today against the mere possibility of suffering a loss in the future
2. helps explain why insurance is socially beneficial = peace of mind
3. Declining Marginial Utility of Money: In most circumstances, each additional dollar that I have is worth slightly less to me. First, I buy things I really need, then somewhat need, and etc… buying insurance when times are good, economically, shifts dollars which I do not value as much (b/c do not need as much) to when times are bad (fire, accident, etc.)
E. Law of Large Numbers: foundation of statistics and insurance and also helps to explain the appeal of insurance
1. Example: which is more certain?
a) whether a particular 65 yr. old male w/heart disease will die this year? OR
b) whether the percentage of 65 yr. old males w/heart disease in the U.S. will die at about the same percentage of last year?
c) Answer: Obviously B… basically with larger numbers more able to predict the future and thus set accurate premiums.
(a) Questions Insurance Companies ask: how much to charge? how many claims will result? the value of the risk?
F. Diversification: insurance institutions diversify risks in several ways. They insure many people against the same kind of risk, thereby diversifying their exposure to that particular risk. They insure people against different kinds of risks, thereby diversifying their exposure to different kinds of risks.
1. Diverisfying risk and law of large numbers allows for certainty by seeing the past to predict the future
a) Life Insurance: cheap b/c pretty predictable that large amts. of people live to a certain age
b) Terrorism Insurance: expensive b/c so uncertain future
G. Four Problems that hinder ability to spread risk:
1. Moral Hazard: theoretical tendency for insurance to reduce incentives to:
a) protect against loss (ex ante)
(1) Example: leaving a car door unlocked, comfortable in the knowledge that if the car is stolen the insurance company will pay
(a) “Torch my ride” example
(b) not reducing risk b/c do not care what happens to insured property
(2) NOTE: Types of loss where we do not expect ex-ante MH = health, disability, and life insurance… b/c don’t want to see yourself get harmed.
(3) Insurer-side ex ante MH:
(a) an agent doing what is in his best interest instead of acting for the principal, or
(b) an insurance broker who refers the principle to the insurance company which gives him the highest commission rather than the one that suits the customer best.
(c) insurance company not checking information before policy signed… collecting premiums… and then denying coverage based off of misrepresentation/or for no reason once claim filed
b) to minimize the cost of a loss (ex post)
(1) Example: not caring very much about what it costs to repair a car as long as the insurance company will do it; not shopping around for lowest price
(a) Insurer-side ex-post MH:
i) will have incentive to exercise authority to serve their own interest… minimize the loss and pay least amt… interest to undervalue claim
ii) Insurance K are different than garden variety K… if insurer doesn’t pay the claim, there is no opportunity for cover, if the promise to pay is not fulfilled, the insured is in a vulnerable position (makes the insured more likely to settle b/c need money quick usually b/c of their desperate situation)
c) Moral Hazard = information problem b/c insurance companies could eliminate moral hazard if they could determine what people would do to be careful in the absence of insurance and then require people to take same level of care w/ insurance
d) 3 Fundamental strategies for addressing moral hazard:
(1) contract on care: providing financial incentives for the policyholder to invest in some form of durable protection, such as a car alarm, dead bolt lock, or sprinkler system (incentives, little side deals to have them do it)
(a) i.e. discounts to those who are low risk to stay in pool
(2) community of fate: make it so that the policyholder feels some of the pain of the loss (i.e. deductible so that the policyholder pays the first x amt.)
(3) contract around highest risks: insurance companies are generally reluctant to insure against intentional harm and why health insurance companies are unwilling to insure against cosmetic surgery
(a) refusing to write certain policies b/c too high a risk
(b) the greater the control the insured has over the loss, the greater the MH
surance arrangements can be neg. externalities… costs imposed by behavior that undercuts public trust in insurance arrangements (i.e. insurance K are vulnerable to decline in public trust)
b) Positive Externality: benefits to people who are not parties to insurance contracts… liability insurance benefits tort victims, who often have no control over the behavior of people who insure them
(1) shows how, absent gov’t intervention, the insurance market will provide less insurance than would be optimal
(2) liability insurance benefits tort victims… makes them feel secure
II. Contract Law Foundations
A. Insurance K Interpretation
1. Traditional approach: contra proferentem (against the drafter)
2. Gaunt v. John Hancock Mutual Life Insurance (1947)
a) Facts: Insured paid premium for life insurance, was given temp. insurance, was given physical exam, lay medical examiner from med. dept. of home office approved, but the home office did not actually approve until after his death BUT would have approved if he had not died.
b) Question: concerned the words of the policy, that if the application, is prior to death approved by company must be read as condition precedent upon the immediately following provision, the insurance shall be in force as the date of the completion of part b (which was approved before he died).
(1) Was the insurance in force between completion of part b and his death?
c) Court: Insurer loses b/c of fairness. The insurance company could take its time to approve in order to avoid paying claims.
(1) contra proferentem requires ambiguity in the language
(a) those who did not know about insurance would have believed they were covered, b/c part b was completed… lay person’s perspective
(b) text was not ambiguous in terms of language in this case… but the court found the language was functionally ambiguous (to a layperson)
(c) Justice Hand: realzies that the PMR can be flawed b/c what is the plain meaning to one educated judge knowledgeable in K, may not be to another normal lay person
(d) Justice Clark (concurring): he would find for the PH b/c of substantive fairness… but to find as ambiguous will allow insurers to change wording, but not address substantive unfairness