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CHAPTER I

THE FUNCTIONS OF FIRE INSURANCE'

FIRE insurance has been defined as "that social device for making accumulations to meet uncertain losses of capital through fire, which is carried out through the transfer of the risks of many individuals to one person or a group of

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All industry involving the ownership of combustible prop erty is more or less subject to risk of loss through fire and the elements, and in all business enterprises it is the desire of the capitalist to eliminate this risk as far as possible. Three methods of elimination may be used: either the capitalist may adopt measures for preventing the origin and spread of fire; or he may decide to carry the risk himself, and as a consequence pay a higher rate of interest on the capital he borrows and puts into the business; or he may buy insurance, and for a definite sum called the premium, transfer the risk to some other person or group of persons called

the insurer.

All three of these methods are commonly used by the capi

'The best treatment of this subject is found in Allan H. Willett's "The Economic Theory of Risk and Insurance." Excellent brief discussions are also found in F. C. Moore's introductory chapter to his work on "Fire Insurance and How to Build," and in Richard M. Bissels's lecture on the "Place of Fire Insurance in the Financial World." These sources, especially the first two, have been drawn on to a considerable extent in this chapter.

2 Allan H. Willett, "The Economic Theory of Risk and Insurance," Macmillan Co., New York, 1901, p. 106.

talist of to-day, and the cost of each enters into the cost of production. The extent to which each is used by the capitalist will depend chiefly upon its relative cost. Statistics, however, conclusively show that during each succeeding decade a larger proportion of the country's wealth, subject to the uncertainty of loss through fire, has been protected by insurance carried by companies. The fire-insurance business of the country, and for that matter insurance along all important lines, has had a most remarkable development during the last twenty-five years. Less and less of the total risk is borne by the capital in the industry, and more and more reliance is placed upon insurance and fire prevention.

1. Viewed from the standpoint of society in general, as contrasted with the individual property owner, the economic value of fire insurance is indirect rather than direct in character. It is apparent that the insurance of property does not in the least reduce the amount of fire waste. During the last fifteen years over $2,633,226,175 worth of property, representing an average annual loss of $175,548,411, has been destroyed by fire in the United States. This enormous amount of property is wasted annually by fire, and is gone forever. It is not replaced by insurance, since the insurance company has merely collected premiums from the many whose property is not destroyed, in order to indemnify the unfortunate owners whose property is lost.

If insurance, therefore, does not prevent the destruction of property, and does not directly increase the wealth of the community, to what shall we attribute its principal value? The answer is that the real gain derived from insurance is due to the combination of a large number of separate risks into a group, thus making possible the "substitution of certain for uncertain loss." The larger the number of separate risks combined in a group, the less uncertainty will there be as to the amount of loss, since the law of average can be applied with greater precision; and the less uncertainty of loss,

the smaller is the accumulation of money necessary from the many to meet the losses of the few. In fact, if the aggregate of risks combined in a group were so large as to make the application of the law of average perfect, and thus remove all uncertainty as to the amount of loss that will be experienced during a given period of time, the accumulation of money through premiums from property owners (leaving out of account the expenses and reasonable profits of the insurer) would be limited to the exact amount of the expected loss.

It is in the application of this principle that the nature of the gain to society from the institution of insurance becomes apparent. Thus, let us assume that there are five thousand capitalists, owning five thousand houses, valued at $10,000 each, and alike in all respects. Let us also assume that the average annual loss, as shown over a considerable number of years, amounted to of 1 per cent of the value, although for individual years the loss varied from a minimum of of 1 per cent to a maximum of 1 per cent. Now, were there no system of insurance, it is apparent that these five thousand capitalists, if they wished to eliminate the element of gamble, would have to make a liberal addition to the rental in order to cover the uncertainty of loss by fire, to which each is exposed. How much each would add, is a matter of conjecture, but it is conservative to assume that each would demand at least an extra 1 per cent on his investment, or $100 per year, or $500,000 for the entire group, because of the risk assumed. But even at this extra rate of 1 per cent, these house owners would be making a gamble at odds of 1 to 100. The chances are that, if obliged to assume a risk of such great odds, they would demand much more than the extra 1 per cent.

But let us now assume that these five thousand capitalists combine their risks into one group. It must be clear that by doing this they have substituted for the great uncertainty of loss which confronted them as individuals, a certain and defi

nitely known loss, amounting on the average to of 1 per cent, or $50 per house, and only $250,000 for the group. Without the aid of insurance all these capitalists were obliged to increase their rentals by at least twice the amount needed to cover their losses, and at the end of the year the great majority of them, since they had suffered no losses, would have the entire sum as a net gain, while the unfortunate few would be losers to many times the extra sum charged. In each case the charge for the risk was shifted to the houserenter, and he had to pay considerably more each year than he would have been called upon to pay if the uncertainty of loss had been removed by a system of insurance. "The risk that an insurance company carries is far less than the sum of the risks of the insured, and as the size of the company increases the disproportion becomes greater." Just as the rent payer is benefited, so it can be shown that insurance benefits all consumers, since it reduces the cost of practically all commodities by diminishing that part of the cost of production which the manufacturer must necessarily set aside as a fund for protection against risk.

2. The reduction of the element of uncertainty, resulting from a combination of risks, is by no means the only benefit of insurance to the business community. It is very important that insured risks in different localities and in various classes of property should be correctly inspected and rated, and that justice should be done between different property owners. The ability of men to judge such risks varies greatly, and the problems connected with the fixing of rates are difficult and intricate, since the number of elements which makes up the hazard to which insured property is subject is almost infinite. Any one will recognize the difference between a manufacturing plant and a dwelling from the

'Allan H. Willett, "The Economic Theory of Risk and Insurance." New York, 1901, p. 108.

standpoint of fire hazard, and such distinctions exist between a thousand different types of property. Again, hardly two buildings within a given class of risks can be considered the same, since they differ in their construction, their environment, and their equipment of devices for preventing and extinguishing fires. Almost every substance and process of manufacture will, under certain circumstances, be the cause of fire. According to a leading schedule there are more than a hundred features of construction in a single building which should enter into the determination of its rate. There are nearly forty features of the city or environment which are important, and nearly forty more of fire appliances. Lastly, there must be considered the hundreds of possible uses to which a building may be put.

Naturally the task of estimating risks, when surrounded by so many features, all of which must be taken into consideration, should be undertaken only by those who make this a regular business, i.e., by those who engage in the fireinsurance business. To judge between safe and unsafe risks, and charge rates which are just and adequate, requires that the underwriter should have a knowledge of every business which he agrees to insure. As Mr. F. C. Moore states,1 "There is probably no calling requiring so intimate a knowledge of every other as this. He who assumes the risk of a flour mill, for example, should know more of its dangers than the miller himself. . . . Drawing a greater number of contracts in a year than do many lawyers in a lifetime, and standing often face to face with the most perplexing questions of jurisprudence, it may be questioned if he should know less than does the attorney who has made it his profession. Seriously affected by every discovery of the chemist, and liable, at any moment, to have his chances of loss on

1F. C. Moore, "Fire Insurance and How to Build," pp. 22 and 23.

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