Losses must be uncertain.

The rate and distribution of losses must be predictable: To set premiums (prices) insurers must be able to estimate them accurately. This is done using the Law of Large Numbers which states that: The larger the number of homogenous exposures considered, the more closely the losses reported will equal the underlying probability of loss. If the coverage is unique, the insured will pay a correspondingly higher premium. Lloyd's of London often accepts unique coverages. (e.g., the insuring of Tina Turner's legs and Jennifer Lopez's buttocks)

The loss must be significant: The legal principle of De minimis dictates that trivial matters are not covered. Furthermore, rational insurance uses existing insurance when the transaction costs dictate that filing a claim is not rational.

The loss must not be catastrophic: If the insurer is insolvent, it will be unable to pay the insured. In the United States, there is a system of Guarantee Funds that run at the state level to reimburse insured people whose insurance companies have become insolvent. [1] This program is run by the National Association of Insurance Commissioners (NAIC). [2] To avoid catastrophic depletion of their own capital, insurers almost universally purchase reinsurance to protect them against excessively large accumulations of risk in a single area, and to protect them against large-scale catastrophes.

Additionally, “speculative risks” like those incurred through gambling or through the purchase of company stocks are uninsurable.
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Insurance Contract Principles

A property or liability insurance policy is a "personal contract," a "conditional contract," a "unilateral contract," a "contract of adhesion," a "contract of indemnity," and a contract which requires that the person insured have an insurable interest at the time of the insured-against contingency.

Further: An Insurance Contract is one of Uberrima fides. This is a Latin phrase meaning "utmost good faith" (or translated literally, "most abundant faith"). It is the name of a legal doctrine which governs insurance contracts. This means that all parties to an insurance contract must deal in good faith, making a full declaration of all material facts in the insurance proposal. This contrasts with the legal doctrine of caveat emptor (let the buyer beware).
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Personal Contract

Property and liability insurance policies cover persons and not property or operations. Although the terms "insured my house" or "insured my motorcycle" are used commonly, they are not technically correct. The contract between the insurer and the insured is a personal contract between an insuring entity and a person(s) based upon their financial, "insurable interest", in the object or liability being insured. In other words, the question of whether payment is due upon the occurrence of a contingency, and how such payment will be measured, depends upon economic loss suffered by the person(s).
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Conditional Contract

Property and liability insurance policies are said to be "conditional contracts" because the obligation of the insurer to perform may be conditioned upon the insured satisfying certain conditions.
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Unilateral Contract

Only one party is legally bound to contractual obligations after the premium is paid to the insurer. Only the insurer has made a promise of future performance, and only the insurer can be charged with breach of contract.
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Contract of Adhesion

Property and liability insurance policies are said to be "contracts of adhesion" because the insurer and insured parties are of unequal bargaining power where the insured party cannot negotiate the terms of the contract and must take the offer of the insurer as made. Importantly, the rule of law regarding "contracts of adhesion" is that any ambiguities resolve in favor of the insured.
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Contract of Indemnity

Property and liability insurance policies are said to be "contracts of indemnity" because the purpose of insurance is to indemnify the insured—that is, to make good a loss that the insured has suffered. The principle of indemnification is that the insured should not profit from the policy. This does not preclude that the insured will suffer some loss. In fact, many policies include a deductible which guarantees that the insured will pay part of each loss himself.
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Insurable Interest

Insurable interest is one wherein economic loss would be suffered from an adverse occurrence to the person(s) insured.

A contract of insurance is valid in law only if the insured has an insurable interest—that is, if he has a legally recognized financial relationship with the subject matter of the insurance and stands to lose out if that subject is damaged.
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Indemnification

An entity seeking to transfer risk (an individual, corporation, or association of any type) becomes the 'insured' party once risk is assumed by an 'insurer', the insuring party, by means of a contract, defined as an insurance 'policy'. This legal contract sets out terms and conditions specifying the amount of coverage (compensation) to be rendered to the insured, by the insurer upon assumption of risk, in the event of a loss, and all the specific perils covered against (indemnified), for the term of the contract.

When insured parties experience a loss for a specified peril, the coverage entitles the policyholder to make a 'claim' against the insurer for the amount of loss as specified by the policy contract. The fee paid by the insured to the insurer for assuming the risk is called the 'premium'. Insurance premiums from many clients are used to fund accounts set aside for later payment of claims—in theory for a relatively few claimants—and for overhead costs. So long as an insurer maintains adequate funds set aside for anticipated losses, the remaining margin becomes their profit.
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Insurer’s Business Model

Profit = Earned Premium + Investment Income - Incurred Loss - Underwriting Expenses.

Insurers make money in two ways. Through underwriting, the process through which insurers select what risks to insure and decide how much premium to charge for accepting those risks and by investing the premiums they have collected from insureds.

The most difficult aspect of the insurance business is the underwriting of policies. Based on a wide assortment of data, insurers predict the likelihood that a claim will be made against their policies and price products accordingly. To this end, the industry uses actuarial science to quantify the risk they are willing to assume. Data is analyzed fairly accurately to project the rate of future claims based on a given risk. Actuarial science uses statistics and probability to analyze the risks associated with the range of perils covered, and these scientific principles are used to determine the insurers overall exposure. At the end of a given policy, the amount of premium collected minus the amount paid out in claims is the insurer's underwriting profit.

An insurer's underwriting performance is measured in their combined ratio. The loss ratio (incurred losses and loss-adjustment expenses divided by net earned premium) is added to the expense ratio (underwriting expenses divided by net premium written) to determine the company's combined ratio. The combined ratio is a reflection of the company's overall underwriting profitability. A combined ratio of less than 100 percent indicates profitability, while anything over 100 indicates a loss.

Insurance companies also earn investment profits on “float”. “Float” or available reserve is the amount of money, at-hand at any given moment, that an insurer has collected in insurance premium but has not been paid out in claims. Insurers start investing insurance premium as soon as it is collected and keeps earning interest on it until claims are paid out.

In the United States, the underwriting loss of property and casualty insurance companies was $142.3 billion in the five years ending 2003. But overall profit for the same period was $68.4 billion, at the result of float. Some insurance industry insiders, most notably Hank Greenberg, do not believe that it is forever possible to sustain a profit from float without an underwriting profit as well, but this opinion is not universally held. Naturally, the “float” method is difficult to carry out in an economically depressed period. Bear markets do cause insurers to shift away from investments and to toughen up their underwriting standards. So a poor economy generally means high insurance premiums.

Insurers currently make the most money from their auto insurance line of business. Generally better statistics are available on auto losses and underwriting on this line of business has benefited greatly from advances in computing. Additionally, property losses in the US, due to natural catastrophes, have perpetuated this trend.
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Gambling analogy

Some people consider insurance a type of wager (particularly as associated with moral hazard) that executes over the policy period. The insurance company bets that you or your property will not suffer a loss while you put money on the opposite outcome. The difference in the fees paid to the insurance company versus the amount for which they can be held liable if an accident happens is roughly analogous to the odds one might expect when betting on a racehorse (for example, 10 to 1). For this reason, a number of religious groups, including the Amish and some Muslim groups, avoid insurance and instead depend on support provided by their communities when disasters strike. This can be thought of as "social insurance," as the risk of any given person is assumed collectively by the community who will all bear the cost of rebuilding. In closed, supportive communities where others can be trusted to step in to rebuild lost property, this arrangement can work.

However, most societies could not effectively support this type of system, and the system will not work for large risks. For very large risks, Western insurance can also run into difficulties. This is the reason why most U.S. homeowner's insurance does not cover floods. A company that sells homeowner's insurance in a given city can accurately estimate the number of claims it would have to pay due to fires, tornadoes, and other smaller-scale disasters. However, a flood may impact a large percentage of the city and the company might be unable to deal with this. A prime example of this is the flooding in New Orleans as a result of Hurricane Katrina. For the same reason, losses due to war and earthquakes are generally excluded. In the case of floods and earthquakes (which are smaller-scale than war) homeowners can purchase separate insurance from national companies with larger resources, which are able to distribute the risk across regions rather than individual buildings.

In gaming or gambling, the game is fixed at the start so that the odds are not affected by the players. However, to obtain certain types of insurance, such as fire insurance, policyholders are often required to conduct risk mitigation practices, such as installing sprinklers and using fireproof building materials to reduce the odds of loss to fire. In addition, after a proven loss, insurers specialize in providing rehabilitation to minimize the total loss.

While insurance is analogous to gambling in terms of risk and reward, the main difference is in the motivation behind the process (risk seeking vs. risk avoidance). When gambling, you are assuming risk that you would not otherwise be exposed to that has the possibility of either a loss or a gain (speculative risk). (Perhaps put differently, in a gambling transaction the relationship between the bettor and the subject is created through the bet itself; for an insurance transaction, there is an exogenous relationship, usual economic or familial, that is connected to the insurance—which is a way of restating the insurance interest requirement.) With insurance, you are managing risk that you could not otherwise avoid, and which does not present the possibility of gain (pure risk). Risk management, the practice of appraising and controlling risk, has evolved as a discrete field of study and practice. Avoiding, mitigating and transferring certain risk creates greater predictability for consumers and business, and allows people and organizations to use risk intelligently to maximize their opportunities.

Historically, gambling has been considered an uninsurable risk. Recent developments, however, have led to the invention and patenting of new types of insurance to protect against gambling losses. An example is United States Patent 6,869,362, "Method and apparatus for providing insurance policies for gambling losses"
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History of insurance

Early methods of transferring or distributing risk were practiced by Chinese and Babylonian traders as long ago as the 3rd and 2nd millennia BCE respectively. Chinese merchants traveling treacherous river rapids would redistribute their wares across many vessels to limit the loss due to any single capsizing. The Babylonians developed a system which was recorded in the famous Code of Hammurabi, c. 1750 BC, and practiced by early Mediterranean sailing merchants. If a merchant received a loan to fund his shipment, he would pay the lender an additional sum in exchange for the lender's guarantee to cancel the loan should the shipment be stolen.

Achaemenian monarchs were the first to insure their people and made it official by registering the insuring process in governmental notary offices. The insurance tradition was performed each year in Norouz (beginning of the Iranian New Year); the heads of different ethnic groups as well as others willing to take part, presented gifts to the monarch. The most important gift was presented during a special ceremony and when a gift was worth more than 10,000 Derrik (Achaemenian gold coin weighing 8.35-8.42) the issue was registered in a special office. This was advantageous to those presented such special gifts. For others, the presents were fairly assessed by the confidants of the court. Then the assessment was registered in special offices.

The aim of registering was that whenever the one who presented the gift registered by the court was in trouble, the monarch and the court would help him or her. Jahez, a historian and writer, writes in one of his books on ancient Iran: "... and whenever the owner of the present is in trouble or wants to construct a building, set up a feast, have his children married, etc. the one in charge of this in the court would check the registration. If the registered amount exceeded 10,000 Derrik, he or she would receive an amount of twice as much."

A thousand years later, the inhabitants of Rhodes invented the concept of the 'general average'. Merchants whose goods were being shipped together would pay a proportionally divided premium which would be used to reimburse any merchant whose goods were jettisoned during storm or sinkage.

The Greeks and Romans introduced the origins of health and life insurance c. 600 AD when they organized guilds called "benevolent societies" which acted to care for the families and funeral expenses of members upon death. Guilds in the Middle Ages served a similar purpose. The Talmud deals with several aspects of insuring goods. Before insurance was established in the late 17th century, "friendly societies" existed in England, in which people donated amounts of money to a general sum that could be used in case of emergency.

Separate insurance contracts (i.e. insurance policies not bundled with loans or other kinds of contracts) were invented in Genoa in the 14th century, as were insurance pools backed by pledges of landed estates. These new insurance contracts allowed insurance to be separated from investment, a separation of roles that first proved useful in marine insurance. Insurance became far more sophisticated in post-Renaissance Europe, and specialized varieties developed.

Toward the end of the seventeenth century, the growing importance of London as a center for trade led to rising demand for marine insurance. In the late 1680s, Mr. Edward Lloyd opened a coffee house which became a popular haunt of ship owners, merchants, and ships’ captains, and thereby a reliable source of the latest shipping news. It became the meeting place for parties wishing to insure cargoes and ships, and those willing to underwrite such ventures. Today, Lloyd's of London remains the leading market for marine and other specialist types of insurance, but it works rather differently than the more familiar kinds of insurance.

Insurance as we know it today can be traced to the Great Fire of London, which in 1666 devoured 13,200 houses. In the aftermath of this disaster Nicholas Barbon opened an office to insure buildings. In 1680 he established England's first fire insurance company, "The Fire Office," to insure brick and frame homes.

The first insurance company in the United States provided fire insurance and was formed in Charles Town (modern-day Charleston), South Carolina, in 1732.

Benjamin Franklin helped to popularize and make standard the practice of insurance, particularly against fire in the form of perpetual insurance. In 1752, he founded the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire. Franklin's company was the first to make contributions toward fire prevention. Not only did his company warn against certain fire hazards, it refused to insure certain buildings where the risk of fire was too great, such as all wooden houses.

In the United States, regulation of the insurance industry is highly Balkanized, with primary responsibility assumed by individual State insurance departments. Whereas insurance markets have become centralized nationally and internationally, state insurance commissioners operate individually, though at times in concert through a national insurance commissioner's organization. In recent years, some have called for a federal regulatory system for insurance similar to that of the banking industry.

In the State of New York, which has unique laws in keeping with its stature as a global business center, Attorney General Eliot Spitzer has been in a unique position to grapple with major national insurance brokerages. Spitzer alleged that Marsh & McLennan steered business to insurance carriers based on the amount of contingent commissions that could be extracted from carriers, rather than basing decisions on whether carriers had the best deals for clients. Several of the largest commercial insurance brokerages have since stopped accepting contingent commissions and have adopted new business models.