The Act of God designation on all insurance policies; which means, roughly, that you cannot be insured for the accidents that are most likely to happen to you.
Alan Coren, 1938–2007
After reading this chapter, you should be able to:
1. define insurance and describe the concepts of risk allocation and risk pooling;
2. list the fundamental problems faced by insurers;
3. give examples of insurable interests;
4. describe the various insurance coverages available to pilots, fixed-base operators (FBOs), airlines, and airports;
5. discuss the difference between an insurance contract and an exculpatory contract.
Nearly everyone has some type of insurance. The state tells us that we must have automobile insurance in order to operate our car or truck, the bank tells us that we must have homeowner’s insurance in order to secure a mortgage, and many employers provide some sort of health insurance. Despite this, insurance is a mystery to most. Few know if they are adequately covered or what their policies actually provide. This chapter will attempt to demystify the subject. It will define insurance and explain how it works. It will also describe, in as much detail as possible in one chapter, the coverages available to pilots, FBOs, airlines, and airports.
WHAT IS INSURANCE?
Insurance is a contract by which an insurer promises to provide money or give something of value to an insured in the event that the insured is injured or damaged as a result of a stated contingency. An insurance contract is called a policy and it is a method of transferring or allocating risk.
As we have seen, all pilots and aviation businesses face risk, which may be defined as a prediction concerning potential loss based on known and unknown factors. In other words, risk is uncertainty. The pilot faces the risk that his or her plane will be damaged in an accident, necessitating costly repairs. The aviation business faces the risk that a customer will slip and fall in its facility, resulting in costly litigation. Both face the risk that a plane will crash, creating potentially catastrophic liability. The rational individual or business seeks to manage these risks. As we have seen in previous chapters, this may be done through the choice of business organization or through accident prevention programs and procedures. Certain risks, however, may be difficult to manage in this manner. The rational individual or business weighs the likelihood of such an occurrence, which is usually small, against its potential financial impact, which is usually large, and decides how much money they would be willing to pay in consideration to transfer or allocate the risk to an insurer. This consideration is called a premium.
It is clear why an insured wishes to transfer an otherwise unmanageable risk, but why would an insurer be willing to assume such a risk? In short, because there is a profit to be made. An insurer is in a position to spread the allocated risk over a pool, consisting of a large number of insureds facing similar risks. This risk pool can be viewed as a sort of common contingency fund. Each insured is charged a premium which is small compared to the amount they stand to receive should they sustain a loss. Risk pooling is made possible by the fact that although the likelihood of an occurrence is unknown for a given insured, over a large number of insureds, it becomes statistically predictable. Thus, an insurer knows with reasonable certainty how much it will have to pay out if it insures a particular group or pool. This allows the insurer to calculate the premium required from each insured to cover the overall loss and provide a profit. In addition, an insurer may have the expertise necessary to implement effective accident or loss prevention programs, further minimizing risk and increasing profit.
It is important to note that risk pooling only works if the risks faced by each insured in the pool are independent. In other words, the fact that one insured incurs a loss does make it more likely that another will. For example, if a group of insureds hold automobile policies across the country, the fact that one driver has an accident does not make it more likely that another will. In contrast, if a group of insureds all hold homeowner’s policies in Florida and the home of one insured is damaged in a hurricane, it is very likely that the other insureds will be filing claims as well. The latter case represents a situation where risk is not effectively spread, the contingency fund is overwhelmed, and profit is eliminated. Insurance companies deal with this problem by excluding dependent risks from coverage or by charging a substantially higher premium to include them.
Adverse Selection and Moral Hazard
Additional problems faced by insurers include adverse selection and moral hazard. Given a group of potential insureds, some clearly face greater risks than others. Some are careful and cautious; some are inattentive and reckless. The more risk an insured faces, the greater their desire to transfer it. Adverse selection is the problem that those most likely to purchase insurance are those most likely to need it. One way of dealing with this problem is by setting high premiums for all insureds, ensuring that all losses will be covered and a profit will be realized. However, this creates an undesirable situation where only the worst-risk insureds will purchase insurance. This problem can be dealt with more effectively by screening insureds and selectively increasing premiums. How does an insurer assess how much risk a given insured actually faces? One way is through the use of deductibles. A deductible is an amount, stated in terms of dollars, which an insured must pay in the event of a loss. A high-risk insured, confident that a loss will occur, seeks a low deductible, whereas a low-risk insured will probably be willing to live with a higher deductible, knowing that a loss is improbable. Deductibles also benefit insurers by eliminating numerous small claims which are expensive to handle.
Moral hazard is a problem in that, with the risk of loss transferred to an insurer, an insured has little incentive to avoid risky behavior. Insurer-directed accident or loss prevention programs help to alleviate this problem. A co-payment, or amount that an insured must pay in the event of a loss stated in terms of a percentage, also tends to alleviate this problem.
Parties and Terminology
The parties to an insurance contract are the insurer, the insurance company, and the insured, the holder of the policy or party covered by its terms. The insurer may also be referred to as an underwriter, a term which is often misused. Underwriter may refer to the insurance company assuming a risk or to an individual within the insurance company who assess and selects the risk and sets a premium. Under some policies, such as a life insurance policy, benefits are paid to a third party rather than the insured upon the occurrence of a stated contingency, such as the death of the insured. This third party is called a beneficiary.
Quota Sharing and Reinsurance
Most general aviation policies are issued or carried by a single insurance company or underwriter. This insurer alone bears responsibility for paying losses covered by the policy. The high dollar-value risk involved in most airline or airport policies, however, is further spread through a process called quota sharing. Quota sharing allows several insurers to assume a portion of the total risk under a policy in return for a portion of the premium.
Similarly, insurers often spread risk through reinsurance. Reinsurance is an agreement between a primary insurer, or ceding company, and a secondary insurer, or reinsurer, by which the reinsurer agrees to accept some of the ceding company’s risk under one or more policies. This can be done on a policy-by-policy, or facultative, basis or it may be done on an across the board, or treaty, basis. Regardless of whether the agreement is facultative or treaty, the reinsurer will accept risk from the ceding company on either a pro rata, excess, or surplus basis. Under a pro rata arrangement, the reinsurer receives a percentage of the premium collected under a policy and pays the same percentage of losses. Under an excess arrangement, the reinsurer pays only those losses exceeding some predetermined amount. A surplus share arrangement combines elements of both the pro rata and excess arrangements. Under a surplus share arrangement, the reinsurer pays a percentage of the entire loss, but only if it exceeds some predetermined amount.
Agents and Brokers
Insurance may be obtained from two sources. It may be obtained from a direct writer, an insurance company itself, or it may be obtained from an indirect writer, an agent or broker. An insurance agent works for or has an agency relationship with one or more insurance companies and receives a percentage of the premiums collected on policies sold for these companies. Although agency is beyond the scope of this chapter, suffice it to say that the insurer is bound by the agent’s actions.
A broker is also paid on a commission basis, but is not affiliated with any particular insurance company. A broker is an independent contractor and acts as the agent of the applicant or insured. Thus, when an insured comes to a broker to obtain a policy, the broker is free to shop around to find the best available deal for the insured. In the aviation insurance field, the distinction between agents and brokers is generally not significant because most individuals selling policies are licensed as both.
Another important individual in the insurance world is the insurance adjuster. When an insured suffers a loss and a claim is filed, the insurer assigns an adjuster to investigate the validity of the claim, determine whether or not the loss is covered by the policy, and negotiate a settlement. These adjusters can be employees of the insurer or independent contractors.
THE INSURANCE CONTRACT
At first glance, an insurance contract looks much like a wager. An insured is betting that an occurrence may happen (although hoping that it won’t) and an insurer is betting that it will not.
Two things distinguish an insurance contract from a wager. First, an insurance contract is not intended to make an insured rich in the event that a loss occurs; rather, it is intended to indemnify the insured or return them, as closely as possible, to the financial position they were in before the loss occurred. This is similar to the purpose of tort law, which was discussed in Chapter 3. Second, an insurance contract is based upon an insurable interest. An insurable interest is something from which the insured derives pecuniary benefit. Put differently, if the insurable interest were destroyed, the insured would sustain monetary loss. Examples of insurable interests range from the common to the bizarre. An individual benefits from the continued existence and preservation of his or her real and personal property. He or she may also benefit from the continued life and health of a relative. An athlete stands to lose if he or she damages his or her knee before he or she makes the pros. A business may benefit from the continued life and health of a key executive – it also stands to lose if a supplier breaches a contract. All of these interests may form the basis of an insurance contract. The above, in order, are examples of property insurance, life insurance, accident insurance, key-person insurance, and fidelity or guaranty insurance. These classifications are based upon the insurable interest or risk involved.
An important classification to both individuals and businesses in this litigious world is casualty or liability insurance. Liability insurance performs two important functions. First, it provides a legal defense in the event that the insured is sued for injury or damage to another. This includes the investigation of allegations, the hiring of attorneys, consultation with experts, and the payment of all associated expenses. Second, it covers any corresponding settlement or judgment – within the limits of the policy – if the insured is found to be liable.
The nature of the insurable interest determines whether it must exist when a policy is obtained or simply at the time that a loss occurs. Life insurance and key-person insurance, for example, require that an insurable interest exist at the time a policy is purchased. Property insurance, however, simply requires that an insurable interest exist at the time a loss occurs.
THE INSURANCE POLICY
Insurance policies, which establish the rights and duties of insurer and insured, are often very complicated and difficult to read. However, they generally consist of five major parts and are governed by the general principles of contract law.
The first section of an insurance policy is the declarations section. This section identifies who the policyholder is, what property or interest is insured, the coverage provided, the policy period, and the premium. It also indicates whether there are any deductibles or co-payments and to whom a claim should be made in the event of a loss. The effective date of a policy depends on how the policy was acquired. A policy acquired through an agent is usually effective at the time an application is made and a binder is written. A binder is a document prepared by an agent when an application is made which states the essential terms of the pending policy. A policy acquired through a broker, however, is usually not effective until it is actually received by the broker. Of course, a policy may state that it begins at some predetermined future time. An insured has the right to cancel a policy at any time. An insurer may cancel a policy only under certain circumstances, such as when premiums are not paid or upon the discovery of false statements or material omissions in an application, and is required to provide prior written notice. A policy may not be canceled for discriminatory reasons or for reasons contrary to public policy.
The second section of an insurance policy is the definitions section. As in all areas of law, this section is extremely important. In the definitions section the insurer explains how they define each of the important terms in the policy. Some definitions may have the effect of limiting coverage and some expanding it. Disagreements or ambiguities may be resolved by the courts and words will generally be given their plain meaning in light of the nature of the coverage. Unresolvable ambiguities are usually construed in favor of the insured.
The third section of an insurance policy is the coverages section and, as the name implies, it outlines in detail the coverages provided, including any applicable limits. Coverage limits are usually stated on a per occurrence (or single limit), per passenger, or per person basis. Relevant to aviation, this section also outlines any required pilot qualifications or use restrictions which apply to insured aircraft. Each of these will be covered in detail later.
The fourth section of an insurance policy, the exclusions section, takes back coverage granted in the previous section. For example, the coverage section of an automobile policy may provide rather broad protection in the event of an accident. The exclusions section, however, may take back coverage if the accident occurs in a foreign country. Many general policies contain such exclusions or waivers and an insurer has the burden of showing the facts necessary to defeat recovery. Anything that happens that is not directly attributable to the actions or inactions of a person is excluded in all insurance policies. People often falsely refer to such things as an “Act of God” exclusion. The late Alan Coren once stated “the Act of God designation on all insurance policies; which means, roughly, that you cannot be insured for the accidents that are most likely to happen to you.” While the quote offers comedic effect, in actuality the assertion of such an exclusion is rare by most insurance providers.
The final part of an insurance policy, the endorsements section, includes addendums to the rest of the policy, which is usually a standard form. It could include special definitions, coverages, or exclusions.