Principles of insurance ..

Front matter

AW LIBRARY

J^»t

Cornell University Library KF1167.G35 v.2

Preface

The literature on insurance is considerable in amount, but that which is accessible for use in schools and colleges is meager. Government documents, official reports of insurance companies and of organizations of insurance officials and employees, pamphlets and published addresses on the subject are the chief sources of the best information on insurance.

It is therefore because of the conviction of the importance of insurance, the character of the literature, and the increasing importance of the subject in the curriculum of educational institutions that this discussion is offered.

The two volumes on life and fire insurance are offered, not as a complete discussion of these two important forms of insurance, but rather as a statement of what is conceived to be the more important considerations which should receive study in a general course in life and fire insurance. The material has been selected on the basis of the author's experience in teaching the subject, his experience in the business, and his association with insurance organizations. As textbooks, they will need to be supplemented by the instructor, by reference reading as well as by the use of policy forms, company reports, government reports, and other available material.

The author is aware that his discussion of certain questions relating to the regulation of insurance is vi PREFACE

opposed in some cases to the prevailing public sentiment and practice. But it has been the purpose, not only to state as briefly as possible the important facts and principles of life and fire insurance, but also to provoke thought and discussion on certain mooted questions in insurance.

An effort has been made to select such readings on each topic as would be most helpful. Much of the best literature is either in pamphlet form or in the insurance journals. An exception is made in the case of insurance statistics. Such annuals as the Insurance Year Book of the Spectator Company leave little to be desired in the way of statistical literature. An exception is also to be made in the case of the German and French literature, much of which is of a very high character and in general much more extensive than the literature in English. Few references to this literature have been made ; first, because most of it is not accessible to the reader of this book, and second, because this is an elementary discussion of the principles and practices of

insurance.

W. F. GEPHART.

Washington University.

Chapter I Page

The Historical Development of Fire Insurance . . 1 Periods in the development of fire insurance. Informal organizations. Lack of data for scientifically conducting fire insurance. Absence of wide diffusion of individually owned property. Character of the industrial life. Guilds in their fire insurance activity. Early fire insurance plans in England. The effect on fire insurance of the London fire of 1666. The organization of Friendly Societies, Mutual, and Stock Companies. Early English Companies, their plans of insurance and field of operation. The Bubble Period and its effect on fire insurance. Early American fire insurance organizations. Importance of Marine Insurance. The effects of the New York fire of 1835 on fire insurance in the United States. The early forms of regulation. Development of Mutual Companies. The work of the National Board of Fire Underwriters. Development of the Standard Fire Policy.

Chapter II

The theory of the group risk. The function of the company. Essential mutuality of all insurance organizations. Comparison of the stock and mutual principle. Impossibility of self-insurance. Comparison of the risk in fire and life insurance. The economic character of the payment to the insurer. Relation of fire insurance to production. How capital insures capital. Relation of insurance to credit and distribution. How the economic costs of fire insurance may be reduced. Causes of the large losses by fire in the United States. Insurance as a competitive and monopolistic business. To what extent is fire insurance subject to the law of decreasingj:ost ?

viii CONTENTS

Chapter III Page

The Business Organization of Fire Insurance ... 45 Fire insurance as a public and as a private business. Classes of private organizations. How a company is organized. Importance of an initial surplus. Departments and officials of a stock company. Character, success, and field of operation of Mutual Companies. Mutual and Stock Companies compared. The Lloyds. Inter-insurance Associations. Importance of each class of organizations as to number and volume of business.

CHAPTER IV The Method of Transacting the Business of Fire Insurance ... 61

Departments of a stock company. The importance of the Home Office and Branch Offices. The examination of the risk proposed by the Agent. The Field Force. The work of the early agents. Position of the agent with respect to the insurer and insured. The General and the Special Agent. The formation of Unions. Classification of Underwriters Associations. The Report of the Agent. The Broker and the advantages and disadvantages of the Brokerage System. The process of writing a risk. The problem of commissions. Flat and contingent commissions. Board and non-board companies.

Chapter V

Hazard defined. The hazard in fire and life insurance compared. General classes of hazards. The time and place element in hazard. Monthly and Annual Fire Losses. Periodic fluctuations in the loss ratio. Physical hazards, Construction, Occupancy, Protection, and Exposure. Effect of height, area, character of roof and openings on hazard. Combustibility and Damageability. Public and Private Protection in their effect on hazard. Radiated, absorbed, and transmitted exposure. The Conflagration Hazard and its distribution. The Moral Hazard. The Increase of Hazard.

CONTENTS ix

Chapter VI Fags

The rate defined. Class and specific rates. The rate in its price aspect. Factors determining the rate. Classification in relation to rates. The two aspects pf classification. Rates in fire insurance and life insurance compared. Limitation in theory and practice of classification as a basis of rate-making. Judgment made rates. Schedule Rating. Universal Mercantile and the Analytical System. Method of determining rates. Agencies for determining rates. Public and Private rate-making. Rating Bureaus. Competition in rate-making and its effects. Discrimination in rates. Kinds and methods of discrimination. Union and non-union companies. Is fire insurance a public or private business? A competitive or monopolistic business ? Public evils resulting from enforcing competition. Summary.

Chapter VII

The policy contract defined. Its indemnity and personal character. Its limitations. Early policies. Influence of English forms on American fire insurance contracts. Early state requirements as to standard provisions in the policy. The Development of the Standard Fire Insurance Policy. Terms of this policy. Extent to which these terms have had judicial interpretation. Explanation of the Standard Policy Riders. Specific, Blanket, Open and Floating Policies. The Use and Occupancy Policy. Rent Insurance Policies. Leasehold Insurance Policies. Profit Policies. Automatic Sprinkler Leakage Policies.

Chapter VIII

The settlement of the loss as a real test of the contract. The loss settlement as a cause of legal contests. The " conditions subsequent " in the policy. Cash Value as the basis of settlement. Methods by which the insurer may make settlement. Period for settlement. How cash value is to be x CONTENTS

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determined. Agreement, appraisal, and acquirement as bases of settling loss on contents. The work of the adjuster. Subrogation ; its basis in the common law. When the insurer becomes subrogated. Indemnity as the characteristic of the fire insurance contract Court decisions on subrogation and indemnity as the basis of the contract Reasons for difference of opinion of courts.

CHAPTER IX Limitation of Liability and Distribution .... 183 Clauses limiting liability. Reasons for these limitations. The Three-fourth Value Clause. Its basis. The fire insurance rate as a tax. The Three-fourth Loss Clause. Valued Policy Laws. Reasons for their enactment. The Co-insurance Clause. Its purpose. When it is applicable. Illustrations of its effect Results of a failure to use it Its theoretical and practical justification. Insurable interests. The Mortgage Clause, and its contribution feature.

Chapter X

The Premium. The fire insurance and the life insurance premium compared. Is the fire insurance premium the same as a tax ? Premium receipt on different classes of contracts. The reserve, its origin, and character. The reserve as a reinsurance reserve and as an unearned premium income. To what extent is it an asset for the company ? Uncertainty of the sufficiency of the reserve on single risks. Method of calculating the reserve. The reserve in fire and life insurance. Why the prevailing method of calculating the reserve is a disadvantage to new companies. The surplus. Its origin and purpose. The surplus in fire and life insurance compared. The investment of fire insurance companies. State regulation of investments. The expenses of fire insurance organizations. Analysis of character. Fixed expenses. Causes for their large amount. The explanation of the increase in expenses. To what extent can expenses be reduced ? The importance of taxes as an item in expenses.

CONTENTS xi

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Dividends ; sources, and amount. Underwriting and total profit. Have profits in fire insurance been large ? Failure of fire insurance companies explained.

Chapter XI

Statistics of the fire loss. Its economic significance. Urban and rural losses. Comparison with European fire loss. Causes of the difference. Loss in different sections of the United States. The theory of personal liability in the United States in its relation to losses by fire. Over-insurance, arson, and incendiarism in their relation to the fire loss. Causes of fires. Agencies for preventing and controlling fires. Private and Public Agencies. Fire-proof Buildings. The work of fire insurance organizations in preventing fires. The work of the Laboratory of the National Board of Fire Underwriters. Automatic Sprinklers. Their efficiency. Building codes. Fire Marshals. Fire Departments and Water Works. Fire Alarm Systems. Schedule Rating in its effect on the Fire Loss.

CHAPTER XII The Relation of the State to Insurance .... 277 Character of the insurance contract as a cause of state regulation. Common fallacies as to insurance. Is insurance a public or private business ? The decisions of the Supreme Court as to its public character. Is insurance a monopolistic business ? Effect of rate wars in fire insurance. Attempts to bring insurance under the regulation of the Federal Government. Early methods of regulating life insurance. Present methods of regulation. How a life insurance company is organized. The examination of life insurance companies. The liquidation of life insurance companies by the state. Taxation of life insurance companies. The regulation of fire insurance companies centers about the rate question. Fire insurance as affected by anti-trust legislation. What authority should make the fire insurance rate ? Discrimination in fire insurance rates.

Chapter I The Historical Development Of Fire Insurance

Social Basis of Insurance. — The development of fire insurance may be divided into two periods : First, that of informal organizations, composed of the mutual associated efforts of groups and acts of government which from a very early period in the history of human society sought to reduce and repair the damage occasioned by the occurrence of fire. This instinct of cooperation and sympathy for a member of the group suffering a loss expressed itself in many forms in early society. Second, that of the business organization of fire insurance when definite organizations either in form of corporations, mutual associations, or individual business units sold protection from the damages incident to a fire for a price called a premium.

Conditions Preventing Early Development of Insurance. — It was not until property was held by a large number of the social group, that is, not until many different individuals were directly affected by the losses due to fire that formal organizations could exist for the purpose of insuring against losses by fire ; nor could fire insurance as a business exist until there was some understanding of the causes of fires and some perception of the regularity of the occurrence, that is, of the law of averages. Fire insurance, like all forms of insurance, is predicated upon the regularity of recurrent events. The data for the determination of such a law of averages were not available in the early history of industrial society. Nor was there a fund of capital which could be productively loaned to meet the requirements of modern fire insurance as a business.

The essential features of all insurance • — foresight and cooperation — were largely non-existent. Chance, as the determining factor in human affairs, was a common belief. Cooperation is powerfully stimulated if the individuals by whom it is applied perceive some direct benefit. This was not true in the earlier time when individual ownership of property was not important. The motive did not exist even if the knowledge of the means to apply insurance had been present. Property was largely owned by a minority of society, and its loss was not so seriously or directly felt, since the position of power enjoyed by the minority made it possible for them to recoup in part or in whole their loss from the labor of the dependent majority.

It is to be recognized that the character of the industrial life and the property did much to retard the development of fire insurance. The industrial life was simple. A large part of the economic activities was confined to the pastoral and agricultural industries, or to other simple extractive industries. What manufacturing there was, centered very largely in the household. There were no large factories with their concentration of large property values. The merchandising was also of a very simple character, usually with no large stock of goods, located at a particular point. Society did not in the earlier day possess a large, diverse stock of goods with large amounts located at one point and owned or traded in by a single individual or firm. It is also to be noted that the earlier centers of civilization in western Asia and southern Europe had less need for the continuous use of fire, and that the chief building material — clay and stone — did much to reduce the danger of loss by fire. There were no furnaces, electrical wiring, matches, and the many other modern causes of fire. It is true that the cities were often poorly constructed from a modern fire insurance standpoint, and that there were few modern firefighting devices. Disastrous fires were therefore not unusual occurrences. London had had, for example, disastrous fires in 798, 892, 1086, 1212, before the conflagration of 1666.

Precursors of Modern Insurance. — As the industrial life became more complex, as manufacturing and commerce with its accompanying institutions of exchange and marketing developed, the need and occasion for formal organizations to supply fire protection arose. Long before the establishment of these business organizations, many different kinds of associations and activities existed to prevent fires, and to assist those who suffered from their occurrence.

Magistrates or priests in very early society were accustomed to levy compulsory contributions among the people of a city for the purpose of aiding those who had suffered by fires. It will be observed that this was an early form of assessment insurance by the state and differs in its essentials from the modern practice of Fire Insurance in that it included all the members of the community. In this respect, indeed, it was superior to our present plan, since all property owners do not under our present plan insure their property and aid in paying the fire loss which in theory may as well fall on the uninsured as on the insured. That is to state, the ideal plan would be to have all property insured, since all property owners as well as non-property owners are interested in having property insured and are benefited by the existence of insurance. This is true in part because the non-insured property is better protected as a result of the many activities of fire insurance companies, and organizations, public and private, which endeavor to reduce the hazard of fire. If the state should take over the business of fire insurance, the only logical method of conducting it would be the compulsory insurance of all property.

The Insurance Aspect of the Guilds. — During the Middle Ages the Guilds provided from the contributions of their members funds to repair the losses by fire which the members suffered. This was but one of the many activities of these Guilds, which existed for the mutual benefit of their members. For example, in the Guild of the Palmers, established at Ludlow (Herefordshire) in 1284, an ordinance provides that " when it happens that any of the brethren or sisteren of the Guild shall have been brought to such want through theft, fire, shipwreck, fall of house, or any other mishap . . . then once, twice, and thrice but not a fourth time, as much help shall be given to them out of the goods of the Guild, as the Rector and Stewarts, having regards to the deserts of each and to the means of the Guild, shall order."

There is also some evidence that these Guilds were sometimes formed or developed into organizations whose chief purpose was the protection of the members' property.

In the fifteenth century there was found in Schleswig-Holstein an organization called Brandgilden, which probably developed from the earlier organization known as Briiderliche, which was formed to protect in general the property of its members. The Brandgilden were municipal organizations interested in mutual fire insurance protection.

In 1635 a petition was made to King Charles I of England for authority to insure property against fire losses but there is no record that a patent was issued.

Early Fire Insurance Proposals in England. — Three years later another petition was made to the King for letters patent for the term of forty-one years to establish a fire insurance organization. It was proposed to insure houses within the city of London and its suburbs at a rate of 12 pence per annum for every house yielding £20 yearly rental. Fire engines and watchmen were to be provided for every ward in the city, as well as reserves of water conveniently located for use when a fire occurred.

The modern fire department, the fire watchman, the salvage corps, and water protection are suggested at this early date. The King referred the petition to the Attorney-General who considered the propositions " reasonable if the petitioners according to theyre offer be tyed to theyre limitations and that no man be pressed to come in to subscribe but every man left to his voluntary choyce."

In the petition, the proposer had agreed to deposit £5000 with the government, which should be increased until it amounted to £10,000. This sum was to be held by the government and be invested by it so as to earn £5 on the £100. This was a forerunner of the present deposit required of stock fire insurance companies by the state to guarantee the loss payments. The petitioners had also suggested compulsory insurance, hence the modification suggested in this particular by the Attorney-General. The King granted the petition and ordered the Attorney-General to prepare a bill, granting the desired privileges.

The contest between Charles I and Parliament was probably responsible for the failure of the proposal. After Charles II ascended the throne, a proposal was made to him for the formation of a fire insurance organization. The king favored the project and recommended it to the consideration of the common council of London. The council rejected the proposal " because they thought it unreasonable for private persons to manage such an undertaking, or that any one but the city should reap the profits of the enterprise." It will be observed that this was an early expression of the belief in government insurance, which in the United

States has only of late years been a subject for general discussion.

On the continent there had existed organizations for protecting property against fire. In 1753 there was published in Hamburg an essay on Insurance by one Magens in which it is stated that a " Fire Casse " had long existed in that city, which insured the principal houses to the value of 15,000 marks "to be paid in case of their being burnt."

The great London fire of 1666, which destroyed over eighty per cent of the buildings in London, did much to accelerate the development of fire insurance as a business in England. Immediately after this destructive fire many different proposals were advanced for insuring houses.

Dr. Nicholas Barbon, who had been " a leading builder of the city of Lond," opened in 1667 an office for insuring houses and buildings. This was a system of individual underwriting and was similar to that which already existed in marine and life insurance, especially in the case of marine insurance. Individual underwriting at this time was quite possible, owing partly to the difference in the amount of the premium received at that time in comparison with the small premiums now received. The amount insured on each risk was also usually small.

Many plans for insuring property were laid before the Council of London with a view of having the city assume this work. In 1681 the city council resolved " to undertake ye insuring of all Houses within the city and Libertyes."

In the meantime Barbon and some associates had organized in 1680 a joint stock corporation, known as the Fire Office, with a capital stock of £40,000. The premiums were based upon the rental value of the property; and on frame houses the rates were double those on brick, thus illustrating one of the earliest examples of schedule rating, although only the construction feature of the hazard was considered.

Early Discussion of Public versus Private Fire Insurance. — When the city of London decided in 1681 to insure property, discussion arose in respect to the merits of public and private insurance. Broadsides appeared, and the newspapers contained numerous discussions of the subject. The Fire Office issued a pamphlet of " Enquiry whether it be to the interest of the city to insure houses from Fire; and what advantage the insured may expect more than from the Insurance Office already settled." Many phases of the discussion are similar to those of the present day in reference to the respective merits of state and private insurance. The city of London retired from this particular venture after a year's experience. • The Fire Office continued in business and in time came to be known as the Phcenix Office from its badge of a Phoenix in the flames.

Mutual versus Stock Insurance. — Soon, however, this private corporation was to have a competitor. In 1683 a proposal was issued " for securing Houses from any considerable Loss by Fire, by Way of Subscription and Mutual contribution." This was the first of the Friendly Societies and the real beginning of modern mutual fire insurance. It will be understood from the preceding descriptions that the mutual principle of protecting members of a social group against the losses due to fire had long existed. But the mutual organizations which were now to be formed were characterized by more formal organization with specific duties and privileges on the part of its members. Each member of this Friendly Society agreed when they joined to pay not to exceed 305. for every £100 of insurance. This sum was to remain in the members' possession, except that 6s. 8d. of every 305. should be paid in as a pledge and at the expiration of the insurance was to be returned to the member. In addition each member was to pay is. \i. for every £100 of insurance for the expenses of administering the Society. Some mutual association of a later day which made inadequate provision for loss payments and expenses might well have taken a lesson from the plans of this early mutual company. There arose at once a discussion between the private joint stock company, — the Fire Office, — and the Friendly Society, as to the respective merits of the plans. Dr. Barbon argued that there could be " no insurance unless there be a fund settled that is both certain and able to make good the loss." Whereupon the Friendly Society replied that " the Fund in the Fire Office is neither greater nor the Insurance cheaper than in the Friendly Society." The Fire Office officials appealed to the Crown for an order to compel the Friendly Societies to cease writing insurance, and after much discussion the society was ordered to refrain for a year from insuring property. After obtaining Letters Patent the Society could operate every alternate three months. The Fire Office thus obtained practically for a time a monopoly. However, other organizations were soon formed both of a private and of a mutual character, so that the old Fire Office soon had considerable competition.

Early English Companies. — In 1710 Charles Povey, who as early as 1706 was underwriting and issuing fire insurance policies, organized the company of London Insurers, although the company was partly formed in 1709. This organization soon came to be known as The Sun Fire Office for insuring Houses, Goods, Wares, and Merchandise from Loss and Damage by Fire. Thus was established one of the oldest of present fire insurance companies, and it is to be noted that it insured goods, wares, and merchandise. The earlier companies had confined their activities to houses and buildings. This Sun Company, named such because of its use of a sun as a sign, wrote policies in the cities and towns of Great Britain, whereas other companies had confined their business to a more limited territory. Separate policies were required for houses and goods. .The policies were in effect when signed by three or more members of the company of the insurers. No policy was for a greater sum than £500, but no guarantee was given that losses to this amount would be paid. The payment depended upon the amount of available funds. This fund originated from a payment by each policyholder of 3s. per quarter after the first quarter, when the payment was 45., the one shilling being for the stamp tax. One shilling was reserved out of each quarter's payment to

THE DEVELOPMENT OF FIRE INSURANCE n

constitute a fund, and within ten days of the close of each quarter all moneys so reserved were divided among the sufferers in proportion to their respective losses, not exceeding £500 on each policy. The articles in the agreement of this early organization contained many of the provisions of present policy contracts, such as notice and sworn statement of losses, and change of residence. The similarity of present fire and marine insurance policies to those of an early date is much greater than that of life insurance policies.

In 1696 there had been formed a purely mutual organization, the Amicable Contributors for Insuring from Loss by Fire, which soon came to be known as the Hand-in-Hand. This society confined its insurance at first to Houses and Buildings. In 1714 another mutual society, the Union or Double Hand-in-Hand, was formed, which insured the contents of buildings, thus supplementing the activities of the older Hand-in- Hand Society. Thus it will be observed that before the close of the first quarter of the eighteenth century, all the present-day types of fire insurance organizations were in existence, with the possible exception of the special mutuals, such as Factory Mutuals and other mutuals insuring risks in a single industry or business. That is, the stock plan, the mutual plan, private insurance and public insurance had been tried. Competition, as is the case at present, was keen between the stock and mutual organizations. Each endeavored by pamphlets, broadsides, and other methods to prove the superiority of their plan.

The Bubble Period and Fire Insurance. — The period of speculation, exemplified in the South Sea Bubble and other similar ventures, had its effect on the development of fire insurance. Marine and life insurance were first used as a basis of such speculative ventures, but by 1720 similar organizations were based upon fire insurance. Companies were proposed with capital of £2,000,000, representing an enormous amount of capital for this time ; many shares of stock were sold ; the purchasers, as in the case of most of the other speculative companies of the period, often received no return. A pack of playing cards issued during the period with a verse on each card sets forth the follies of the period. The seven of clubs expressed the spirit of the times in reference to fire insurance in the following words :

Projecting sure must be a gainful trade, Since all the elements are bubbles made. They're right that gull us with the dread of fire For fear makes greater fools than fond desire.

However, other companies of the best character were being formed. The Royal Exchange and the Corporation of London Assurance were chartered in 172 1, although the former did not place its fire division in operation until a year later. Older organizations were changing their plans to meet the developing conditions. The Sun provided a regular joint stock plan which would produce a fund to guarantee the payment of its policies, and the London Assurance Corporation enlarged its classification of risks. However, of the twenty-one important companies formed between the opening of Dr. Barbon's office in 1667 to the formation of the Liverpool Company in 1777, only nine existed in 1780. Among the more important companies of these nine, the following, with their dates of organization, may be noted : the Hand-in-Hand, 1696 ; the Sun, 1710; the Union, 1714; the London Assurance Corporation, 1721 ; the Royal Exchange, 1721 ; and the Liverpool, 1777.

In 1782, under the premiership of Lord North, the first regular tax on fire insurance was levied. This was a percentage duty on the sum insured.

Some of the English companies had by the close of the century opened offices on the Continent and in the United States, and by the middle of the following century they had property insured in the United Kingdom to the extent of half a billion pounds.

It has seemed advisable to devote the chief part of the discussion to the earlier history of fire insurance for the following reasons :

First, modern fire insurance had its genesis in Great Britain, and the development in the United States has been in many respects similar to that in England.