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Understanding Insurance Risk

Updated on September 7, 2009

Risk and Insurance

All uncertainties in insurance fall into one or the other of two broad categories: speculative or pure. A speculative uncertainty is one in which there is both the possibility of a financial gain and the possibility of a financial loss. For example, a property owner is exposed to the speculative uncertainty that various forces may either increase or decrease the value of his property. Generally, speculative uncertainties may not be insured.

A pure uncertainty involves the possibility of a financial loss only. For example, a property owner exposed to the uncertainty of loss by fire, a pure uncertainty, can only lose.

Uncertainty and Risk

Pure uncertainties are termed risks. Risk is uncertainty about financial loss. It includes both the concept of uncertainty, which is a state of mind, and the concept of loss itself, which is generally thought of as failure to retain possession or enjoyment of something of value. Risk (that is, pure uncertainty) is the raw material of the insurance mechanism.

Perils and hazards work together to cause loss. Perils are the causes of loss (such as flood, theft, fire, accident, and sickness). Hazards are conditions that lie behind particular perils—that is, they affect the probability that a given peril will cause a loss, and they affect the potential severity of loss, or both. There are physical hazards such as weather, location, and type of construction, and there are moral and morale hazards. Dishonesty (a moral hazard) or carelessness (a morale hazard) both can lead to a greater likelihood of a loss or a more severe loss.

Personal risks involve loss events that touch the person, such as financial loss arising out of premature death or disability. Generally, the lives involved include one's own immediate family or key business associates- persons in whom the assured has an insurable interest.

Property risks involve loss events that touch directly the property covered. Losses include the expense of repair or replacement and lost income (real or dollar) derived from property use. The property that is the subject of insurance is usually owned by the insured.

Liability risks involve loss events that concern the person or property of others, and for which an insured is legally responsible either through contract or tort law.

Methods of Treating Risk

There are a number of ways to treat risk, including: (1) retention, (2) elimination of loss possibility, (3) hedging, (4) transfer of risk, and (5) anticipation of loss.

Many individuals simply assume risk, retaining it by conscious decision or by indifference. Some risk is retained because there is no alternative; in other risk, retention is a superior method of treatment.

Some risks are managed through the elimination or minimization of hazard. This is the underlying rationale of the loss prevention and loss minimization practices of individuals, business firms, and insurers.

Risk may be reduced by transferring the loss possibility to another person or organization. For example, a surety bond guaranteeing the completion of a building in accordance with the specifications involves the transfer of the risk from the person having the building constructed to the surety.

Risk can be reduced by anticipation, that is, by measuring in an aggregate sense the losses that probably will occur. Statistical inference and other estimating devices (broadly referred to in insurance as actuarial techniques) are important tools in anticipating losses. This ability, based on past experience, to estimate future losses with reasonable accuracy reduces risk (decreases uncertainty). Insurance involves anticipation combined with an accumulation of funds from individuals who transfer their risks to the insurer. The insurer must have funds in order to pay the anticipated losses. An insurance policy, signed by the insurer and the insured, sets forth the terms of the agreement.

Insurers, hoping to anticipate the dollar volume of losses, rely on the theoretical principle of large numbers. A practical statement of this principle, a part of the subject of probability, is: as the number of units of experience or exposure increases, the margin of error in estimating the expected losses decreases, thus reducing the risk to the insurer.

Events that are the result of pure chance occur with increasing regularity as the number of instances observed becomes larger. Just as the National Safety Council in the United States predicts with reasonable accuracy the number of motorists who will meet death on the highways, insurers with statistics on millions of lives can foretell reasonably accurately the number of people from a given population who will die in a stipulated period.

Desirable Characteristics of an Insurable Risk

Although insurance is a logical and in many ways remarkable method of dealing with risk, not all uncertainties of financial loss can be handled in this way. In order for insurance, especially private voluntary insurance, to work, the risk involved should meet reasonably certain broad tests. Most of these tests are designed to enhance the predictability of loss results. The desirable characteristics of an insurable risk are summed up in the tests that follow:

  1. There should be a large group of relatively homogeneous exposures so that the experience indications of the past for that group will have meaning in the future for a group with essentially the same exposure characteristics.
  2. The cause of loss should be unlikely to produce loss to a great many independent exposures at the same time. Catastrophic events (riot, war, mass nuclear radiation) require special consideration.
  3. The occurrence of the loss and its severity should be accidental: the loss event and its severity should be beyond the control of the person insured. In order to minimize moral hazard, the law requires that, to have a valid insurance contract, a person must possess an insurable interest in the subject of the insurance - he would lose financially if the subject (person or property) were injured, damaged, or destroyed. The purpose of the insurance contract is to provide indemnification, compensation for a loss or an injury already sustained to the extent that the value of that loss or injury can be determined. Where the insured is indemnified only, and can not profit, then the incentive to bring into being the event covered by insurance is minimized.
  4. Perils covered should produce a loss that is definite and easily identifiable (the loss should be difficult to counterfeit).
  5. The potential loss caused by a peril should be large enough to cause financial hardship (it is uneconomic for a person to insure small losses that he can easily pay).
  6. The probability of loss should be sufficiently small that the cost of insurance would be economically feasible. The loss and loss adjustment expense plus the administrative expense and acquisition cost - that is, the total amounts for these items included in the premium - should not be prohibitive in relation to loss potential.
  7. The probability of loss should be calculable - that is, statistics relating to actual experience should be available as a base for rates or prices.
These requisites are ideal standards for the application of the private insurance mechanism. Many forms of insurance, private and governmental, are written in violation of one or more of these requirements. Nevertheless, they are valuable guides to insurers in identifying problem areas and developing appropriate underwriting rules.

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