A guy walks up to a blackjack table in a casino and places a ten-dollar chip in the betting area in hopes of besting the dealer. He’s taking a risk that he may lose that $10, but also has the chance of earning $10 if he has a winning hand. He can even earn $15 if he’s dealt a 2-card 21, also called a blackjack.
Not All Risk is Insurable
The above situation is an example of what’s known as an uninsurable risk since the risk of losing that $10 chip cannot be accurately calculated. Losing money at a casino cannot be insurable by definition since insurance risk must be unexpected in both its timing and its impact. It’s a condition where the risk of loss is unknowable. As an insurance company underwriter, your job is to limit losses by not taking on risks that will likely create a loss for your company. And as any regular casino goer knows, the odds are always in favor of the house!
Acceptable Insurance Risk
Risk can be classified into two broad categories – pure risk and speculative risk:
Speculative Risk – those risks capable of producing either a profit or a loss, such as the gambling risk previously discussed. These types of risk are almost never insured by insurance companies, as they lack the core elements of insurability which include “due to chance,” statistical predictability, and random selection.
Pure Risk – this is a risk that can’t be controlled, cannot be predicted, and has two possible outcomes – no loss or complete loss. Pure risk carries no opportunity for profit or gain. Most pure risks are insurable.
Pure risk may be divided into three categories:
- Property
- Personal
- Liability
There are four ways in which pure risk can be mitigated:
- Reduction
- Avoidance
- Acceptance
- Transference (such as when buying insurance coverage to transfer the risk to an insurer).
Examples of Insurable Risk (Pure Risk)
Property risk involves damage to property due to factors that are out of your control such as fire, severe weather, vandalism, theft, lightning, hail, etc. Personal risk involves you directly and can be the cause of some sort of loss of earnings or assets or can create an increase in expenses. Injuries or poor health may cause a loss of income or earning power and may create significant medical bills and savings depletion. These losses may all be insured against by obtaining the proper type of insurance coverage.
Liability risks may involve your being held responsible for causing property damage, injury, or death to a third party. Examples may include being sued by someone who slips, falls, and becomes injured on your icy sidewalk or driveway or when a neighborhood child gets injured when jumping on your back yard trampoline or when using your back yard swimming pool. Liability risk is ever-present when you’re operating a motor vehicle, since you may be held liable for any accident you cause. This insurable risk may be transferred to an insurer by obtaining liability coverage, which most states require for those who own and operate motor vehicles. Liability protection is also typically part of a standard homeowners’ insurance policy. Liability protection can easily be increased by obtaining an umbrella policy.
Pure Risk Versus Speculative Risk
As mentioned earlier, insurance companies generally only insure against pure risks, also known as event risks. This includes any uncertain situation where the prospect of a loss exists but no opportunity for financial gain is present.
Speculative risk, on the other hand, could produce either a profit or a loss, such as in gambling transactions or business ventures. Speculative risks are almost never insured by insurance companies. Part of your job as an insurance underwriter is to determine whether the risks you’re being asked to underwrite are pure risks or speculative risks.
“Due To Chance”
For a risk to be insurable, it must have the prospect of creating an accidental loss, meaning that it’s been caused by an unintended action that was unexpected in both its timing and its impact. In the insurance industry, this is typically referred to as “due to chance.” Insurance companies are only required to pay out on insurance claims that are caused by accidental means. This protects insurers from having to face losses created by intentional means such as someone burning down their own home or intentionally crashing their automobile in order to collect on their insurance policy.
Insuring Against Pure Risk and the Law of Large Numbers
An insurance risk may be insurable using a number of different types of insurance policies such as personal, commercial, or liability policies. In so doing, the insured is transferring a portion of his or her insurance risk to an insurer in exchange for a specific premium payment amount. Homeowners who purchase homeowners’ insurance, for example, are protecting against potential losses that could be caused by a number of different perils covered in a home insurance contract. When the policy gets issued, the insurer is sharing a portion of the insurance risk with the insured.
For a risk to be insurable it must be predictable, which is made possible with the help of the law of large numbers. Insurers must be able to predict potential loss numbers in order to comfortably accept underwriting a specific insurance risk. As an insurance underwriter, you are continually trying to determine what risks are insurable and, just as importantly, which risks will be good (profitable) for your company to underwrite.
Statistical Predictability
Statistics are an important part of insurance underwriting. As an insurance provider, you must be able to accurately estimate how frequently a specific loss may occur and what the severity of that loss may be. This is the statistical predictability around which the insurance business revolves. Without this predictability, accurate insurance underwriting would not be possible. Being able to accurately predict losses and the severity of these losses are what guide the decision as to whether or not to underwrite a prospective insured and, if the answer is yes, what premium to charge.
Clearly understanding risk is paramount in the process of accurately underwriting any insurance policy. Many divergent factors come into play in developing this understanding, starting with differentiating pure risk from speculative risk and then utilizing all the data and programs available to further your ability to accurately underwrite various coverage.
In property and casualty underwriting, of which home insurance makes up a large portion, one key ingredient needed for accurate underwriting is a complete, accurate, professional property inspection. Insurance Risk Services (IRS) has been providing advanced inspection field reports to their insurance company partners for nearly four decades, helping them consistently make more informed underwriting decisions. Contact IRS for more information on what they can do for you.
