Classification of insurance

Insurance can be classified according to many different aspects. Based on the subject of insurance, we distinguish between personal and property insurance. Based on the nature of loss, we distinguish between fixed benefit and indemnity-based insurance, and finally, in terms of provisioning, a distinction is made between life and non-life insurance. The different subdivisions have different perspectives, so in principle they can live side by side in peace and we can use the terms indemnity plan, non-life insurance, and personal insurance within the same text. However, regulation may highlight some of these, and this is precisely the situation in the EU: it basically draws a borderline between life and non-life insurance.

3.6.1. Classification of insurance based on the subject of insurance

According to its subject, insurance can be divided into two main groups: personal insurance⁴⁵ to protect individuals against the financial consequences of damage to their life, physical integrity and health, and property insurance to compensate for damage to property. We can further break down personal insurance:

44 The distinction between adverse selection and autoselection is a characteristic only of the Hungarian insurance literature. In English, the two are treated together as adverse selection.

45 The Hungarian and English insurance terminology differ here as well. Here we described the Hungarian version. In the English literature, personal insurance includes e.g. home and motor insurance, so it is used much more in the sense of a “retail” insurance.

‚ life,

‚ accident, and

‚ sickness insurance.

The aspect of personal/property classification was reflected, for example, in the structure of the old State Insurance Company in Hungary, where the various property insurance departments (motor vehicle, corporate property, retail property) operated alongside the unified personal insurance department. This subdivision, however, is now somewhat outdated and also reflects the rudimentarily structured insurance supply of the socialist period, namely the insurance monopoly. This is because more modern types of insurance, such as the wide range of liability insurance or legal protection insurance, cannot be implicitly classified as property insurance (although liability insurance originally appeared as a rider attached to such policies).

3.6.2. Classification of insurance based on the nature of loss

The term „nature of loss” refers to a single property of the loss itself, namely whether or not its magnitude can be evaluated, at least in theory. Material damage that can be evaluated both theoretically and practically, may be covered by indemnity-based policies. On the flip side, policies with a fixed benefit are taken out to cover losses of theoretically or simply practically unquantifiable magnitude.

Indemnity plans are typically applied in property insurance, such as insurance against house fire. If a damage occurs, i.e. a fire breaks out in an apartment, the event is first reported to the insurer, then a claims adjuster investigates the scene and assesses the amount of damage, from which the insurer eventually calculates the compensation to be paid. Thus, in the case of non-life insurance, the claim settled by the insurer depends on the actual amount of the damage.

Note that the claim amount depends on the actual amount of damage, so it is not certain that the compensation will correspond with the actual damage. For the sake of clarity, in the following we will distinguish between the concepts below:

Sum insured: The maximum amount of payment to be made by the insurer as set out in the insurance contract.

Insurable value: The value of the insured asset.

Amount of damage: The actual value of the damage or loss incurred.

Amount of loss: The amount determined by the insurer’s claims settlement policy in the specific case based on the amount of damage and the insurable value.

Claim amount: The amount actually paid out of the amount of loss.

The claim amount is capped by a very important rule that “damage profiteering is not allowed”, i.e., the compensation can be at most the amount of the damage. This rule

is important because it keeps the insurer and the client “in one camp,” which ensures that not only the insurer but also the client tries to avoid the occurrence of damage. If, on the contrary, profiteering was allowed from the damage, its occurrence and not its prevention would be in the client’s interest. And the client can do much more for the event of damage happening than the insurer can do to avoid it.

Secondly, the insurer can possibly establish an amount of damage of HUF 1 million, whereas the claim amount is only HUF 500,000. This is what happens in the case of „underinsurance”. Underinsurance means that the sum insured is less than the insurable value, i.e. the magnitude of the actual value of the insured property. In such cases, the claims adjuster not only determines how much the damage was, but also how much it could have been in total, i.e. how much the property was originally worth.

If he finds that the value of the property (the apartment in our example) was HUF 10 million, but it was only insured for HUF 5 million, the insurer considers the property worth 10 million being co-insured by them and the client in 50-50% proportion. In other words, the damage incurred is also borne in 50-50% proportion, so in the case of a HUF 1 million damage, the insurer covers HUF 500,000 and the client also covers HUF 500,000. This method provides an incentive to avoid underinsurance, as it is detrimental to the insurer (in a more valuable asset, a fire, burglar, etc. can inherently do more damage than in a less valuable one). In this example, the compensation is paid on the so-called pro rata basis. However, this compensation principle is not always used (it cannot be used in all cases).

In the case of „premier risk” insurance, the claim amount shall be equal to the amount of damage up to the sum insured. If the amount of damage exceeds the sum insured, the claim amount is equal to the sum insured. The premier risk principle is applied, for example, in certain forms of medical expenses insurance where the insurable value cannot be predetermined.

According to the „total value” principle, there is no upper limit on the claim amount, as opposed to the premier risk principle. Here, the claim amount is always equal to the amount of damage. This principle is widely applied in liability insurance.

The amount of compensation may differ from the amount of damage due to several factors. Insurers tend to exclude minor claims, as these are usually not a particular burden for the policyholder, but their claim settlement procedure is as costly as for large claims. In addition, the number of such minor claims is much higher than that of larger damages.

Refusing to pay a compensation below the deductible is another principle, similar to that of the exclusion of minor claims. Since the amount of the deductible is usually chosen by the policyholder, it essentially means that they can decide on their own what they consider a minor damage. In practice, however, this is often not the case, as policies with high deductibles, i.e. the relatively cheaper ones, are taken out by those in

a less well-off financial situation, while policies with lower deductibles, i.e. the more expensive ones, are taken out by the more affluent, for whom the minor nature of a loss ends at a much higher amount.

In some cases, by paying less than the amount of the loss, the insurer encourages policyholders to take loss prevention activities and also tries to offset the effect of moral hazard. Therefore, if the insurer finds the lack of measures to prevent losses or to reduce the amount of the damage occurred, it will set the compensation at less than the amount of the damage.

However, there are types of insurance where the claims adjustment process described above is inherently hopeless. For example, imagine the situation that a claims adjuster is applied in life insurance! The relatives report the death of the insured, i.e. the loss, and the claims adjuster goes out to the scene and estimates how much the insured has died, how much the relatives are missing them, and so on. Obviously, this is absurd, and therefore only the occurrence of the insured event needs to be proven here. The compensation will be a predetermined amount in the insurance contract, and that is why we call such policies fixed benefit insurance – actually, all forms of life insurance are of this type.

It is also worth noting that some types of insurance form a transition between fixed benefit and indemnity-based insurance, i.e. it is feasible under both principles.

A typical example for this is accident insurance, which is a fixed benefit insurance if the insurer pays a certain percentage of a predetermined amount based on the extent of the resulting permanent injury, and an indemnity-based insurance if the insurer reimburses the medical expenses incurred as a result of the accident.

3.6.3. Classification of insurance based on provisioning

In terms of provisioning, life insurance is completely different from other types of insurance, i.e. all forms of non-life insurance. The reason for this will be discussed later and will not be explained in detail now.

Property insurance is a typical example of non-life insurance. (If we recall the distinction between personal insurance and property insurance, the difference between this and the life/

non-life distinction is that from personal insurance we take accident and health insurance and add it to property insurance as they are technically similar to them.) The term of a typical property insurance policy (unlike long-term life insurance contracts) is one year (although they are usually automatically renewed the following year). Apart from some special factors, the risk is usually the same in consecutive years. It is therefore not necessary to pile up reserves from premiums on an ongoing basis (or at least not to the same extent as in the case of life insurance). In the case of property insurance, the premium for a given year basically covers the losses incurred that year. However, the claims volatility generally observed in property insurance, as opposed to life insurance, is very whimsical. Therefore, property insurance is profitable in some years and unprofitable in others.

The division between life and non-life insurance is tied to an organizational consequence:

insurance companies operating in EU Member States cannot deal with both life and non-life insurance.⁴⁶ This is exactly because of the oftentimes hectic loss patterns of property insurance, which might entice company executives in onerous years to cover the loss from the stable reserves of their life insurance business. To avoid it happening, a life/non-life separation measure had to be taken.

The two main groups of insurance (life and non-life) are also called insurance branches, and the subgroups under these main groups are the insurance classes. Classes of non-life insurance include various types of motor insurance (there are several of them), accident and sickness insurance, etc. The classes of insurance that insurers may be licensed to pursue are covered by the EU insurance directives and (based on them) the Act on the Business of Insurance in Hungary.