Insurance companies and risk: Why insurers deny business to remain viable

While the common stereotype is that insurance companies are averse to risk, it is merely a half-truth.

Actually, insurers tend to avoid risks that are considered substandard or uninsurable. They are also averse to paying claims that were not covered in the insurance contract, but that’s another story.

Insurance is a great social concept, but it is not a charity at the same time. Insurers provide coverage for risks in the hope of remaining profitable.

While some insurers have astronomical profit margins, the risk that they accept to turn over profit is quite significant and potentially devastating to the business.

It may disappoint conspiracy theorists to note that there are several plausible insurance-related and business reasons for insurance companies to avoid or mitigate certain risks.

1) Underwriting losses

When an insurer pays out more money on a policy than it received in premiums for that policy, this is considered an underwriting loss. Often, insurance companied incur underwriting losses without even issuing a policy (for instance, when the insured decides not to accept revised premiums after extensive and expensive medical tests). If insurers insured everything under the sun, the extent of underwriting losses would be prohibitive to them. Proper risk management reduces underwriting losses that can hamper the stability of the insurer.

2) Anti-selection

It is a known fact in the insurance industry that persons or entities that are high-risk are more likely to seek insurance than those who are not. This tendency is known as anti-selection. Naturally, the probability of paying claims if policies were issued in cases of anti-selection are ridiculously high. Therefore, the application process is even more rigorous when higher levels of coverage are involved. To guard against anti-selection, underwriters employ concepts such as deductibles, excess and exclusions.

3) Moral hazard

To expect honesty from all strangers because they are prospective clients is very optimistic to say the least. Moral hazard refers to the risk of dishonesty in an insurance application. This includes non-disclosure and misrepresentations – willful or otherwise. To guard against moral hazard, insurance contracts often contain exclusion clauses and restrictions that serve to complicate them even further.

4) Restricting speculation

I recall a person suggesting to me that insurance is a gamble between the insurer and the insured. While that’s an interesting way of looking at it, insurance was not intended for the insured to make a profit.

This is especially true with commercial insurance, but also applies to life insurance. With life insurance contracts, there should be some parity between the sum assured and the economic value of the insured.

Wagering or speculation is illegal and unethical in the insurance industry. Insurance companies are quick to deny claims or applications if they have evidence that this was involved.

5) Lower premiums

Affordability is a key factor for insurers, or any business for that matter. If premiums were prohibitive, it would be untenable to provide coverage. Some risks are just too high for an insurer to accept, especially risks with potential for catastrophic losses. Just imagine the premium a terminally ill patient would be required to pay for even $50,000 of coverage. The contract would not be favourable to the insurer or the insured. Risk management helps insurance maintain lower premium levels and be able to provide coverage to more individuals or entities.

6) Profitability

It’s no secret that insurance companies aim to make a profit. However, this is not confirmation that insurance is a rip-off. Instead, it is a profit-making industry that provides an important service to society. Insurance is literally risky business, but being too liberal with risks would affect the viability of insurers.

7) Duty to policy holders as a 'going concern'

Catastrophic losses, or frequent and substantial underwriting losses, can lead to an insurer being illiquid or insolvent. Since insurance – particularly life insurance – is a long-term affair, it is imperative that the insurer remain a going concern for as long as possible.

It is also important that clients and other stakeholders have confidence in the insurer’s ability to remain a going concern. Since poor risk selection is inimical to this objective, insurers need to deny certain risks or even refuse business towards this end.

Conclusion

Adherence to sound insurance principles and policies is the main reason why insurers seem risk averse. However, it is imperative that insurance companies must discriminate when it comes to the type, nature and scope of applications that are made for coverage or claims that are made. It is better to think of insurance companies as being in the business of protecting against insurable risks.

Although some insurance companies give the industry a bad name with unwieldy claims processes, poor information and seedy sales representatives, it is unfair to say that insurers are afraid of risk or are in the business of ripping off clients.