PRINCIPLES OF INSURANCE § 1. Chance, unavoidable and average. § 2. Uneconomic character of gambling. § 3. Borderland of gambling. § 4. Insurance: definition and kinds. § 5. Insurance viewed as a wager. § 0. Insurance as mutual protection. § 7. Conditions of sound insurance. § 8. Farmers' mutual insurance. § 9. Joint-stock insurance of property. § 10. Purpose of life insurance. § 11. Assessment life insurance.
Some of these chances are more connected with money lending, others with manufacturing, some with agriculture, others with commerce; but all are present in some degree in every industry. some events are unique in nature and seem unlikely ever to occur again ; others are of a kind occurring so irregularly that no reasonable prediction can be made as to the time and frequency of their occurrences. Still others occur frequently and to many different persons; but no indi vidual can tell when and how they will occur to him. A general average of chances in different lines of business causes some to be called safe, others extra-hazardous. Chance may be favorable as well as unfavorable. Extra-hazardous enter prises must in general afford a higher average of profit in order to induce men to engage in them. It is folly to take a risk without ascertaining its degree as far as general ex perience enables one to choose. But inasmuch and in so far as the gains and losses fall unequally upon different indi viduals, income depends upon chance.
§ 2. Uneconomic character of gambling. This prevalence of chance sometimes tempts men to say that business is a "gamble." But a distinction in principle must be made be tween gambling and legitimate risk-taking. The chances enumerated above are not sought, but avoided as far as pos sible; yet they must be borne by some one if productive enter prise is to continue, and the burden must somehow be dis tributed throughout the community. Gambling is, however, a kind of risk-taking that has a very different economic and moral quality. Gambling creates the hazard, making the gain or loss of income depend on an event that is not a neces sary part of productive enterprise. Typical gambling is the transfer of wealth on the outcome of events absolutely un predictable, as far as the two gamblers are concerned. Ex amples are the shaking of unloaded dice or the honest deal ing of a pack of cards, and the betting on prices in so-called "bucket-shops" by persons having no connection with the market of real things, and seeking to get something for noth ing as a result of mere chance.
Cheating is not a necessary mark of gambling, although the cruder forms of dishonesty, such as the loading of dice or the collusion of horse-owners or of horse-jockeys to deceive the betting public, are so common that they seem often to be an essential feature. Gamblers recognize fair as opposed to unfair methods. Fair gambling is a kind of minor morality within the immoral field of gambling, like the honor found among thieves. The chance-taking in gambling, has no use ful purpose or result outside itself. Betting and gambling do not produce wealth, but merely shift the ownership of ex isting wealth. The gamblers constitute themselves a little fic titious economic circle, and they transfer gains and losses on the turn of events that have no practical objective result within their circle except to determine the direction of the transfer.
Even when fairest, gambling must, in its average results, be uneconomic. In any economic trade each trader gains by getting goods that are, on the marginal principle, to him more valuable than the other kinds of goods he gives But in gambling the winner gets all, the loser gets nothing. If two men of like incomes gamble, the additional desires that the winner is able to gratify are (by the principle of decreas ing gratification) less in amount than the desires that the loser must forgo. As a result the loser is often seriously in jured by the loss of his income, and driven to despair, while the winner makes reckless and extravagant use of his win nings. Easy come, easy go, is the rule of gamblers. More over, gambling reduces the amount of wealth by relaxing the motives of economic activity, diverting energy from pro ductive enterprise, tempting men into dishonesty to offset their losses, and leading them into speculation and embezzle ment.
§ 3. Borderland of gambling. Ranging between the ex tremes of unavoidable risk-taking and of gambling are a num ber of cases of a mixed nature. In nearly all wagers, judg 1 See Vol. I, ch. 5, § 7.
ment in some degree influences the choice of sides. One man bets on a horse whose pedigree and performances he knows thoroughly ; another judges by the horse's appearance as it comes upon the track. The professional bookmakers have the latest possible and most exact information on which to base their bids.
In the bets made on one's own prowess, as on speed in run ning, the chance-taking is still on the uneconomic, side of the borderland, certainly if the running is for the sake of the wager, not for pleasure or for a useful purpose. A premium won by a runner for speed in delivering a message of econ omic importance presents an essential contrast to the winnings in a wager.
Finally, the very borderland of difficulty is reached in the purchase and sale of goods in the market with a view of profit ing by chance changes in price. The purchasing and holding of land, lumber, grain, cattle, and other tangible and useful things, that need to be stored, held for buyers, or taken to market, must be judged liberally. The quality of gambling depends somewhat on the motive as well as on the ability of the trader. The enterpriser dealing with real wealth, and fitted to take the risks both because of his resources and of his exceptional knowledge, needs the motive of gain in such cases, and in a sense can be said to earn socially what he gets. The motive of the uninformed must be a blind trust in luck, and a hope to gain from a rise in prices which they are quite unable to foresee or to explain.
§ 4. Insurance: definition and kinds. The large element of luck in industry due to unavoidable chances has something of the same evil character as gambling. It brings unearned prizes to some and to others unmerited losses. It must there fore be a benefit to the community, if this element of unavoid able chance cannot be reduced as a whole, at least to regu larize it and make it exactly calculable for any individual. In this way each may be encouraged by the more certain pros pect of receiving a reward proportionate to his efforts and abilities. This desirable condition has in many respects been accomplished by means of insurance.
Insurance is a guaranty of partial or complete indemnity against a financial loss that will result if an event of a speci fied kind occurs. The person seeking some surety against the possible loss is the insured; the person contracting to in demnify against the loss is the insurer; the written contract of insurance is the policy; the price paid by the insured in fulfilment of his part of the contract is the premium; the amount paid when a loss has been incurred is the in demnity; and the person to whom the indemnity is paid is the beneficiary (who may or may not be the insured).
The insurance with which we are here concerned is that which gives financial indemnity. This is given for loss of expected net income, when by chance either receipts are less or costs are more than average. The two main classes as regards kinds of loss are property insurance and personal insurance. Property insurance is that which indemnifies for loss of one's possession in specified ways, such as by fire, by the elements at sea (marine), by hail, lightning, or cyclone, by death (of valuable animals), by robbery, and by break age (as of window-glass). Personal insurance is that which indemnifies the beneficiary for loss of income as the result of various happenings to persons, the chief being death, acci dent, sickness, invalidity, old age, and unemployment. The principle of insurance is being constantly extended to new subjects. The Jeffries-Johnson and the Dempsey-Carpentier prize-fights were insured against rain. Frequently race horses, the fingers of pianists, the lives of ball-players, and the throats of singers are now insured. Summer hotels in England regularly insure for large sums against more than so many days of rain per season. Insurance is capable of further development in a variety of directions.
§ 5. Insurance viewed as a wager. Insurance, without question a highly useful thing, appears, paradoxically, to be in its outer form a bet. The large merchant with many ves sels used in many kinds of business had in the days before marine insurance an advantage in distributing his losses over a number of voyages. Antonio, the wealthy merchant, is made thus to express his security: "MV ventures are not in one bottom trusted Nor to one place; nor is my whole estate Upon the fortune of the present year. Therefore my merchandise makes me not sad." In its early form marine insurance was the attempt of smaller ship-owners to distribute their losses (as could the wealthy merchant) over a number of undertakings, lucky and unlucky. It became customary for a ship-owner to bet with a wealthy man that the ship would not return. If it did come back, the owner could afford to pay the bet; if it did not, he won his bet and thus recovered a part of his loss. Gradually there came about a specialization of risk-taking by the men most able to bear it. They could tell by ex perience about what was the degree of uncertainty, and could lay their wagers accordingly. When several insurers were in the same business, competition forced them to insure the ves sel and cargo of the ordinary trader for something near the percentage of risk involved. The insurance thus tended to become a mutual protection to the ship-owners; what had to be paid in premiums to cover risk came to be counted as part of the cost of carrying on that business.
Every legitimate form of insurance exhibits the character istics that it reduces loss at the margin where it is felt most keenly. The difference between insurance and gambling, thus, primarily in the purpose of insurance, which is not to increase artificially the risk that the insured runs, but to neutralize or offset an already existing chance. The insurance bet is what is called a "hedge." § 6. Insurance as mutual protection. The difference be tween gambling and insurance lies further in the collective method of insurance, which combines the chances scattered among a number of persons. Insurance does not increase the total of risks and of losses, but merely combines, averages, and distributes them equally among all the insured. This eliminates the chance element to the individual by converting it into a regular cost to all members of the group. Modern insurance is conducted either by enterprisers for profit, or by mutual companies; but in any case in large measure the losses in insurance are mutually shared, as the premiums (plus interest earned) equal the total losses plus operating expenses and profit, if any is made. Each insured gets a contract of indemnity for the payment of a sum that will help cover the losses of others. Such an exchange is mutually beneficial. The premium comes from marginal income; the loss, if it occurs, would fall upon the parts of income having higher value to the insured. The less urgent needs of the present are sacrificed in order to protect the income that gratifies the more urgent needs of the future. In insurance each party gives a smaller value for a greater ; each makes a gain. The greater security in business stimulates effort. This effect is quite the opposite of that of gambling.
§ 7. Conditions of sound insurance. To be economically sound, insurance must have to do with real productive agents, and with a group of occurrences that, as a whole, are ap proximately ascertainable in advance—however irregularly they may fall upon individuals. The insured must be numer ous enough, and the objects insured so distributed in space and in time, that the "law of large numbers," or of statis tical averages, applies. This means that in any one year the cost will not vary greatly from the average; otherwise the security is weakened.
The beneficiary must have an insurable interest in the property or person insured, that is, the beneficiary must actually suffer a loss by the occurrence insured against, and the amount of the indemnity must not be greater than the loss incurred. Some of the greatest difficulties in insurance arise from the absence of these essential conditions. When there is no insurable interest, or when the indemnity is greater than the loss that may be incurred, the beneficiary may and sometimes does find it to his interest to bring about the socially injurious event insured against. He artificially in creases the loss against which insurance was taken. When the insured sets fire to his own buildings, or drives his auto mobile more carelessly than he otherwise would, he makes an illegitimate use of insurance. Constant efforts are made by insurance companies to guard against these "moral risks," the least calculable of any. Merchants whose stocks have been mysteriously burned two or three times find difficulty in getting further insurance. Formerly insurance was not paid in case of death by suicide; but now usually no such limitation is contained in a policy after a period of one or more years. As men rarely plan suicide years in advance, death by one's own hand some years after taking life insur ance is regarded as coming under the ordinary rules of chance. Yet it is to be feared that this liberal policy serves as a temptation at times to crime and to self-destruction.
§ 8. Farmers' mutual insurance. Property insurance may be viewed as an aspect of enterpriser's but may also, as may any insurance, be considered a form of saving. The premium paid each year may be looked upon as a sum prudently saved and laid aside to repair or rebuild the house when later it burns. Let us suppose that the chance of any one house being destroyed by fire in any one year is 1 in 500 ; then, on the average, the owner of each house would in 499 of the years have no loss from fire and the other year would lose the whole house. If the loss could be
mathematically distributed over 500 houses, each house would burn down 1/500 each year, never more nor less, and fire loss would be a regular cost of repair. If no provision is made for this, the actual income of each owner in his lucky years would be .2 per cent greater (estimated on the cap italization) than, on the average, is the net income of the whole group of owners. A prudent owner of one house, 2 See Vol. I, pp. 365 and 374.
understanding this, could only in small measure protect him self against this loss by setting aside each year $2 for each $1000 of valuation, for any year his whole house might burn down, long before he had laid aside its valuation. If, how ever, one man owned 500 houses of equal value, so situated that no two of them could ever catch fire from the same cause, and if in fact fate so distributed the fires that just one house burned down each year, his loss would be actually distributed in time according to the mathematical proba bility. If 500 different owners of houses, alike but each located apart from all the others, band together, they be come collectively like one owner of 500 houses as regards the chalice of loss in any one year. Still better, if 10,000 owners unite, the distribution of losses will approach much more closely to the mathematical probability.
In fact, a very simple application of this idea has been made in the insurance of farm property. It was a not un common custom in agricultural communities in America for the neighbors to band together to help rebuild a house that had been destroyed by fire, or to take up a collection for the family that was in distress. Insurance affords a more regular, equitable, and effective way of accomplishing the same pur pose, and likewise is a cooperative enterprise of neighbor hood good-will. There are now about two thousand farmers' mutual fire insurance companies in the United States,' with $6,000,000,000 of insurance in force, insuring the property usually up to a maximum of two thirds of the estimated true value. Usually the organization of these companies is simple, their officers unpaid, the overhead expenses very small, and the operations of each company limited to a small area, a township or at most a county.
Premiums are usually not collected, or even determined.
3 These figures were collected by V. N. Valgren, investigator in agricultural insurance for the United States Department of Agriculture. They do not include a large number of similar companies that carry risks other than farm property to an extent greater than 35 per cent.
in advance; but, the losses having been determined at the end of the year, the amount is collected pro rata in propor tion to the face of the policies in force. More often of late, to add to safety and to equalize variations in losses from year to year, a small reserve is laid aside, $3 per thousand dollars of insurance in force being deemed ample for this purpose. Otherwise this is pure assessment fire insurance, and is not only very inexpensive, but very generally safe and convenient. This cooperative plan is, however, less suit able in an urban neighborhood, because of the concentration of risks.
Mutual hail insurance companies provide on a similar plan indemnity for the destruction of growing crops. Forty-one such mutual companies were in existence in 1919, and in recent years have collected premiums ranging from $3,000,000 to more than $6,000,000 a year. The smaller measure of success of these, as compared with the mutual fire insurance companies, is largely due to the irregularity of the losses from year to year and their wide extent when they do occur. The risks are not distributed in a manner suitable for neigh borhood insurance, and mutual companies that are not or ganized and managed in a neighborhood are less honestly and efficiently run. In the attempt to improve conditions, four states (the two Dakotas, Nebraska, and Montana) had hail insurance departments and collected premiums (in the year 1919) of more than $6,000,000, paying losses of three fourths of that amount, and setting aside a surplus. Mutual and state hail insurance premiums are virtually collected on the assessment plan, but it has been found best to collect a definite amount in advance, and, in case of unusual losses, to pro-rate among the losses the premiums collected. The plan of mutual property insurance is likewise being applied to live stock and other farm property.
§ 9. Joint-stock insurance of property. Much the largest part of insurance against fire and other causes of property losses is carried by joint-stock companies, or by so-called mutual companies. Though these companies have, like banks, more of a public character than have most businesses, and are subject to special legislation and supervision by state officials, they were organized and are conducted pri marily for the profit of the owners. Even in many rural districts, especially where conditions are unfavorable to mutual companies, the joint-stock companies have large amounts of insurance in force, and in urban communities they all but completely obtain the business. The joint-stock fire insurance companies collect each year in the United States $700,000,000 in premiums on risks to the value of more than $72,000,000,000. The premium rate thus averages about 1 per cent. In 1917, a fairly representative year, substan tially this group of companies returned to the insured, in pay ment of losses, only 48 per cent of the premiums received, used 34 per cent for expenses, and applied the remaining 18 per cent either to dividends or to surplus. The dividends were nearly 15 per cent of the capital stock (a considerable portion of which represented stock dividends in previous years) and the increase in assets 84 per cent of the capital of the preceding year. When it is considered that 20 per cent of all premiums received are paid in commissions, and that in the case of the higher officials the salaries and commissions run to very large amounts, it appears that the insurance business is exceedingly profitable to the fortunate few in control of these organizations. The starting of new com panies is now attended with increasing risk and cost, so that the existing companies occupy, in some respects, a monopo listic position. Another large group of stock companies (about 200) engaged in casualty, surety, and miscellaneous insurance, very rapidly growing in magnitude and impor tance, now collecting more than one third of a billion dollars a year in premiums, returned (in 1919) to the policy-holders 4 National Board tables for 1917, published in the "Insurance Year Rook," 1918, p. 448. The Spectator Company. Mostly fire insurance, but including marine, automobile, and other business, see also, p. 540.
41 per cent ("including all expenses in connection with pay ment of claims") and expended 40 per cent on actual ex penses of management.
§ 10. Purpose of life insurance. Of all forms of insur ance at present, the most important in the extent of its finan cial operation and as an agency of thrift is life insurance. The total receipts (about $1,800,000,000 in 1919) of life in surance organizations (fraternal, ordinary, and industrial) are almost twice those of all other forms of insurance, and the total assets more than twice as great ($6,800,000,000 in a total of $9,100,000,000 in 1919).
Life insurance is to provide partial indemnity for sur vivors against the financial loss incurred by the death of the insured. Usually the insured is the bread-winner of the family and the beneficiary is a member of his family; but the number and variety of other cases in which life insur ance is provided is now large. In an increasing number of cases the beneficiary is the surviving business partner, a creditor, or a business corporation with an insurable in terest in the life of one of its officers or employees. "Babe" Ruth is said to be insured for $200,000 in favor of the owners of the ball club for which he wields his mighty bat ; Mary Pickford, Charlie Chaplin, and Douglas Fairbanks are each insured for $1,000,000 in favor of the moving picture company, their "producer"; and one of the large motion picture corporations insured the life of its managing head in 1921 for $5,000,000. This is said to be the largest life insurance policy ever written, and it was divided among six or more insurance companies.
Life insurance has been much used by persons mainly dependent on labor salaries, professional fees, and active business profits, rather than from funded incomes. In essence and largely in origin it is a cooperative method of providing for survivors, by all in a group contributing a sum to be given to the families of those dying. Naturally, s See Vol. I, labor incomes, in Index.
the need is most urgent in families not having accumulated wealth. It has of late been extended rapidly, as "indus trial insurance" to wage-earners, in policies never exceeding $1000, but averaging very much less, often being for no more than enough to pay funeral expenses. The premiums on such policies are usually collected weekly and by agents making personal visits. The cost to the insured is, there fore, necessarily high in proportion to the amount of insur ance.
§ 11. Assessment life insurance. Life insurance plans may be distinguished, with reference to the time and method of collecting the premiums, as assessment and reserve insur ance.
In the simplest form of assessment insurance the losses are paid by contributions taken after the losses occurred, each member paying an equal share without regard to age. In a slightly modified plan the assessments are made at the beginning of the year, based upon the expected mortality for the year. Life insurance of this plan is essentially like the mutual fire insurance already described, the percentage of risk for each policy, whether on persons or houses, being assumed to be equal to that of every other policy. The great variation in the chance of loss in the case of various forms of urban property makes simple mutual assessment fire insurance unsuitable in such cases, and even in the case of farm buildings it has been increasingly seen that differ ences in location, grouping, structural materials, nature of uses, condition of water supply, and other means for fight ing fire, cause differences in risk which properly should be recognized. This can be done by classifying risks and in suring on a scale at lower or higher assessment rates. If some concession is not made to the better risks, some enter prising commercial companies will see a profit in giving them a lower rate. Mutual companies which ignore these differ ences feel the effects of "adverse selection" in that they are left with only the more hazardous property.
Now, in the case of life insurance the risk varies with great uniformity (considering the average mortality of large groups of men) according to the one factor of age. The cost of assessment life insurance, therefore, is closely related to the average age of the members composing the group of in sured. The rates are very low in a new organization with a membership of young men ; but each year the average age, and therefore the mortality of the membership, rises, and the annual assessments must be increased. By the constant addition of young members this rise of cost may be retarded. But when these members grow older, a still larger addition of young members is required to keep down the average. But other young men are averse to entering the organiza tion under these conditions; and the result is that the rate of assessment must be steadily increased. Finally failure results, or some form of "reorganization" that drives out the older members. The simple assessment plan carries with it the seeds of its own decay.
To meet these difficulties in part, various modifications of the flat-rate assessment plan are employed, such as classi fication by age, so that each member pays a flat rate according to age at entry ; or large initiation fees at entry, which form a temporary "reserve" to offset increasing mortality in late years. Finally, the policies may be issued on the natural premium plan, by which the members of each age class pay exactly what the insurance costs for the year. Under this plan the company will remain solvent, but the annual cost to the insured rises so rapidly that many surviving members are forced to drop the insurance in later years.
Assessment insurance is sold by stock companies organ ized for profit, by fraternal orders, and by various types of mutual organizations. Many of the stock companies have had a dismal history of hardship to surviving members and of eventual failure. They are reforming or disappearing under the influence of hostile legislation resulting from a better popular knowledge of insurance principles. The fraternal orders have more than ten million policies in force and in comes totaling more than $180,000,000. They combine insur ance with other objects of a benevolent and social character. With good management, a favorable death rate, and very low expenses, some of them have provided protection at very low rates for many years. Many in the past have failed, with disappointment and disaster to the older members. Still others are struggling with difficulties that presage dis solution. Most of them now have some, though inadequate, reserve accumulations, and some have so improved their methods that they begin to resemble reserve companies. The assessment companies average $1.37 reserves per $100 of insurance in force, and get 10 per cent of their total in comes from their funded investments. Even with the favor able conditions under which fraternal orders conduct their insurance business, they eventually must fail unless they adopt rates and policies based upon adequate reserves. Many thousands of present members are paying for insurance at rates that will not suffice to meet the future losses. The assessment plan fails to eliminate the one great risk, that of leaving the survivors without insurance in advancing years.
Gephart, W. F., Principles of insurance, vol. 2, Fire. N. Y. Mac millan. 1917.
Same, Insurance and the state. N. Y. Macmillan. 1913. Huebner, S. S.. Property insurance. N. Y. Appleton. 1913.
Willet, A. H., Economic theory of risk and insurance. N. Y. Long mans. 1901.
Winter. W. D., Marine insurance. Pp. 450. New York. McGraw Hill. 1919.