Risk has a number of alternative meanings.It refers to the probability or threat of loss, injury or damage in a general context.According to businessdictionary.com, risk – in the context of insurance – is not an uncertainty, peril or hazard. It refers to a “situation where the probability distribution is known, but its mode of occurrence or actual value is not.” What this means is that actuaries would know the likelihood of a risk occurring in general, but not whether it would occur at a particular location or how much loss would be incurred if it were to occur.
Insurance is a financial risk-management device that covers many of the liabilities, perils and hazards that persons or entities face. Not all risks are insurable and not all insurable risks are even worth covering. Risks that are insurable must meet specific criteria. The reason for this is to discourage the following:
♦ Illegal activity
♦ Anti-selection – the tendency for high-risk persons or entities to be more likely to seek insurance
♦ Speculation – wagering on the lives or fortunes of others
There are identifiable categories of risk. Risk can be classified in the following categories:
♦ Speculative
♦ Pure
♦ Fundamental
♦ Particular risks
A speculative risk is a gamble. It may result in a loss, a gain or neither. Pure risks differ in that they result in a loss if they occur, but no loss if they do not. Insurance therefore covers pure risks, since there is no element of gain associated with it. This is enshrined in the principle of indemnity, which aims to restore one to previous standing by way of compensation. In non-indemnifying insurance contracts (life insurance for e.g.), financial underwriting helps enforce the indemnifying role of insurance.
A fundamental risk is one that would affect society as a whole or a massive group of people. A particular risk is limited to individuals or a restricted group of people. Insurers generally cover particular risks. They guard against fundamental risks through the principle of proximate cause. Covering fundamental risks would raise premiums too significantly for insurance to be affordable.
To ensure that premiums are affordable and that insurance is for noble reasons, risks covered must be classified as insurable risks. The criteria that must be satisfied for a pure risk to be considered insurable include:
♦ The existence of insurable interest
♦ The loss arising from the risk must be reasonably unexpected and accidental (not caused by the insured or policy owner.
♦ The loss must be measurable, limited to pure financial value and not based on sentimental value.
♦ Losses must not be catastrophic.
♦ There must be a pool of similar risks. Without this, premiums would be too high.
♦ The insurance affected must be in accordance with public policy.
Once these elements are satisfied, a pure risk can be considered an insurable risk. This principle is not only for insurers to follow, but for the insured as well. Good risk management strategy does not suggest that you a risk just because it is insurable. Only risks that would cause severe losses or that would take you months or years to recover from should be considered insurable. Understanding risk gives a better overall idea of the role of insurance in financial planning.