Relevancy of Perils and Hazards in Insurance

Law of Insurance MANISHA KUMARI

ROUGH DRAFT LAW OF INSURANCE Relevancy of Perils and Hazards in Insurance Roll No. 232, Session 2008-2013

Contents
Introduction .................................................................................................................................................. 2 What is Insurance?........................................................................................................................................ 2 Perils.............................................................................................................................................................. 2 Hazards.......................................................................................................................................................... 3 Difference between Perils and Hazards ........................................................................................................ 4 Effects of Perils and Hazards in Insurance .................................................................................................... 5 Conclusion ..................................................................................................................................................... 5

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Relevancy of Perils and Hazards in Insurance

Law of Insurance MANISHA KUMARI

Introduction What is Insurance?

Insurance is the pooling of money by a company from a group of people or organizations, to pay for the fortuitous losses that any of them may suffer. The money that the people pay to the insurance company is called the premium, and for this premium, the company promises to indemnify any of its customers for covered losses. The company may also provide risk management services.1 Another way to look at it is that insurance involves the pooling of losses among its customers. In return for losing a little money in the form of a premium, the customers are indemnified against a large loss. Thus, the average loss among a group of people is substituted for actual losses. To illustrate, consider a sample of 1,000 farms, and suppose that each farm were identical, and had the same value of $300,000 for the house and barn. Over the years, it was discovered that about 1 farmer would have a total loss every year. If a farmer's buildings burned completely, the farmer would be out of $300,000, but if each farmer paid into a fund every year to pay for the fires, then each would only have to pay 300,000/1,000 = $300 per year. Thus, for $300 per year, each farmer can avoid a loss of $300,000 if he suffers a fire that destroys both house and barn. The Amish, a religious sect, do something similar, but instead of pooling money, they pool labor. If a farmer's barn burns down, for instance, then other members of the community pitch in and rebuild the barn. Thus, in exchange for providing some labor periodically, each farmer is protected against major losses. Insurance is the transfer of risk to an insurance company, which pools the losses of many people to provide indemnification for any who suffer covered losses. An insurance company also invests the premiums, since otherwise it would lose the opportunity cost of the money, usually in the form of interest, while it holds it. For a private insurance company to be a going concern, it must earn enough money from premiums and investments to pay not only for the losses of those covered, but also to pay to operate the company and to earn a profit. However, for any private insurance company to be able to insure a risk the company's payout must be fairly predictable and the premiums charged must be affordable.

Perils
Insurance policy designed to provide comprehensive property damage coverage. Other property insurance policies only provide comprehensive coverage for a specific type of property damage. For example, if a person has flood insurance, but the damage that was done to their property was actually done by the wind, they would not be totally covered. The definition of a peril is, the cause
of a potential loss.
1

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CHANAKYA NATIONAL LAW UNIVERSITY | PATNA

Relevancy of Perils and Hazards in Insurance

Law of Insurance MANISHA KUMARI

Multiple peril insurance seeks to eliminate the possibility that the insurer would not be covered by combing popular property damage coverage into one policy.2 The definition of a peril is, the cause of a potential loss.

Hazards
The definition of a hazrd hazard is, the condition which increases the risk or seriousness of a loss. There are four types of hazards known to the insurance professional. Physical hazards are the first which include hazards which arise from structural or operational features of the situation. For example a slippery floor or a huge tree branch in the middle of the road would be classified as a physical hazard. A physical hazard is a physical condition that increases the possibility of a loss. Thus, smoking is a physical hazard that increases the likelihood of a house fire and illness. Moral hazards come from a persons habits and values. The attempt to create a loss for the purpose of collecting from an insurance company is a moral hazard. Another moral hazard is the filing of a false claim. Also, every day someone sets themself up to be the victim of an auto theft. In many cases this is done just to avoid the next monthly car bills which the driver cannot afford. This is a very common moral hazard which may result in prison time for the one who makes that attempt. Moral hazards are losses that results from dishonesty. Thus, insurance companies suffer losses because of fraudulent or inflated claims. The American legal system is a moral hazard in that it motivates many people to sue simply for financial profit because of the enormous amount of money that can sometimes be won, and because there is little cost to the plaintiff, even if he loses. A good example is the current asbestos litigation, which has bankrupted many companies, even though very few plaintiffs show any real evidence of disease, and are unlikely to ever develop any disease that can be shown, by the preponderance of the evidence, to have resulted from asbestos exposure. This type of moral hazard is often referred to as legal hazard. Legal hazard can also result from laws or regulations that force insurance companies to cover risks that they would otherwise not cover, such as including coverage for alcoholism in health insurance. Morale harzards come from carelessness or irresponsibility. An example of a morale hazard is when some driver flies into oncoming traffic while trying to reach their dropped cell phone. Another morale hazard I heard about in a traffic course was that of a teenager driving while attempting to apply visine.

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Relevancy of Perils and Hazards in Insurance

Law of Insurance MANISHA KUMARI

Lastly there are legal hazards which arise from court actions that increase the likelihood or amount of loss. Legal hazards will continue to increase as more people file lawsuits for large rewards. To get a lower insurance rate the insured must do what they can to minimize any of these mentioned risks or hazards. This can be done in many ways. Drive a slower sedan instead of the fast hot rod. Always drive safely. If you want to lower your homeowners insurance rate avoid buying high risky toys like trampolines or swimming pools. Join a health club and get into shape. Eat healthy. Make a list of things you feel may increase your risks on and off the road. Try to avoid these habits on a daily basis.

Difference between Perils and Hazards

The distinction between moral and morale hazard in insurance is one of intention, but in other disciplines, such as banking, the term moral hazard is used in a more general sense that includes morale hazard. Moral hazard is often applied to a receiver of funds, such as a borrower, and means that there is a risk that the receiver of funds will not use the money as was intended or that they may take unnecessary risks or not be vigilant in reducing risk. This definition includes not only intentional dishonesty, but also a change in behavior that results from using someone else's money, which, in insurance, would be described as morale hazard. A peril is something that can cause a loss. Examples include falling, crashing your car, fire, wind, hail, lightning, water, volcanic eruptions, choking, or falling objects. Risk is the chance of loss, and peril is the direct cause of the loss. If a house burns down, then fire is the peril. A hazard is anything that either causes or increases the likelihood of a loss. For instance, gas furnaces are a hazard for carbon monoxide poisoning. A hazard is any condition or situation that makes it more likely that a peril will occur. Hazards include:

physical hazards, like ice on the sidewalks, smoking, or skydiving; moral hazards (most of which are avoidable), like dishonesty (such as burning down the warehouse when your company goes bankrupt to collect insurance money or buying insurance on someone with yourself as beneficiary and then killing them); and morale hazards, like a careless attitude since "insurance will pay for it."

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Relevancy of Perils and Hazards in Insurance

Law of Insurance MANISHA KUMARI

Effects of Perils and Hazards in Insurance Conclusion

Insurance can be regarded as a morale hazard because it increases the possibility of a loss that results from the insured worrying less about losses. Therefore, they take fewer precautions and may engage in riskier activitiesbecause they have insurance. A good example of morale hazard is when the federal government bails out financial institutions who have made bad decisions. Many financial institutions have taken significant risks in the recent subprime debacle by buying toxic instruments, such as CDOs and mortgage-backed securities based on subprime mortgages that paid high yields, but were extremely risky. The financial institutions have considered themselves too big to failin other words, if things started going badly, then the federal government would step in to stop their collapse for fear that the whole financial system will collapse, which is exactly what the federal government did in September, 2008. Freddie Mac and Fannie Mae have both been taken over by the government, and American International Group (AIG) has been propped up by an infusion of $85 billion of taxpayers' money. AIG sold credit default swaps on mortgage-backed securities to buyers, mostly banks, thinking that they could collect the premiums, but would never have to actually to pay for defaultsbut if they were wrong, then the government would save them, because otherwise the banks that had bought that credit default protection could also possibly fail. As recent events have demonstrated all too clearly, this federal government "insurance" creates a morale hazard for financial institutions taxpayers pay the premium, but the big financial institutions, with their overpaid CEOs and managers, receive the benefits!

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