Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the insurance; an insured or policyholder is the person or entity buying the insurance policy. The insurance rate is a factor used to determine the amount to be charged for a certain amount of insurance coverage, called the premium. Risk management, the practice of appraising and controlling risk, has evolved as a discrete field of study and practice.
The transaction involves the insured assuming a guaranteed and known relatively small loss in the form of payment to the insurer in exchange for the insurer's promise to compensate the insured in the case of a large, possibly devastating loss. The insured receives a contract called the insurance policy which details the conditions and circumstances under which the insured will be compensated.
When a company insures an individual entity, there are basic legal requirements. Several commonly cited legal principles of insurance include:
- Indemnity – the insurance company indemnifies, or compensates the insured in the case of certain losses only up to the insured's interest
- Insurable interest– the insured typically must directly suffer from the loss
- Utmost good faith– the insured and the insurer are bound by a good faith bond of honesty and fairness
- Contribution – insurers which have similar obligations to the insured contribute in the indemnification, according to some method
- Subrogation – the insurance company acquires legal rights to pursue recoveries on behalf of the insured; for example, the insurer may sue those liable for insured's loss
- Causa Proxima or Proximate Cause – the cause of loss (the "peril") must be covered under the insuring agreement of the policy, and dominant cause must not be excluded
Insurance can influence the probability of losses through moral hazard, insurance fraud, and preventive steps by the insurance company. Insurance scholars have typically used morale hazard to refer to the increased loss due to unintentional carelessness and moral hazard to refer to increased risk due to intentional carelessness or indifference. Insurers attempt to address carelessness through inspections, policy provisions requiring certain types of maintenance, and possible discounts for loss mitigation efforts. While in theory insurers could encourage investment in loss reduction, some commentators have argued that in practice insurers had historically not aggressively pursued loss control measures - particularly to prevent disaster losses such as hurricanes - because of concerns over rate reductions and legal battles. However, beginning around 1996 insurers began to take a more active role in loss mitigation through building codes.
