Insurance risk is the threat of a future financial loss that an insurer is willing to share with an individual or entity facing that threat. Insurance spreads the risks of policyholders among those policyholders by incorporating the Law of Large Numbers. It’s risk-sharing with other policyholders within the same class and is based on the probability of loss.
There are numerous different types of insurance risks. They fall within these three broad categories:
- Personal Risk – includes threats to your life or your physical well-being.
- Property Risk – includes threats to your personal or business property.
- Liability Risk – includes threats to your financial well-being at the hands of others claiming injury or death alleging you to be at fault.
Risk can further be divided into:
- Economic/non-economic risk
- Pure risk/speculative risk
- Insurable/uninsurable risk
- Controllable/uncontrollable risk
Economic Versus Non-Economic Risk
Economic risks are threats that, if realized, are compensated for damages that cause financial loss. Examples of realized economic risk include financial damages such as:
- Medical bills
- Loss of earning capacity
- Lost income
- Property damage
- Hiring for household services needed
- Vocational rehabilitation
- Out-of-pocket expenses
Non-economic losses are compensated for non-financial losses, often termed “pain and suffering.” These may include humiliation, pain, emotional anguish, emotional distress, reputational damage, and more. These types of damages are more difficult to determine than economic damages and are open to subjective interpretation by those figuring compensation amounts.
Both pure risk and speculative risk involve the potential for suffering a loss. Pure risk, however, has no potential for experiencing gain, unlike speculative risk. For this reason, only pure risk is insurable. An example of pure risk is driving your car. When driving, you’re at risk of being involved in an accident, which represents a loss. With auto insurance, however, you have no corresponding opportunity of profiting, even if you never experience an accident or other type of loss.
An example of a speculative risk is making an investment in the stock market. While you are at risk for suffering a financial loss if the stock you buy loses value, you also have the opportunity of experiencing a profit if that stock rises in value. This type of risk is uninsurable because it represents a potential for either a loss or a gain.
Insurable Versus Uninsurable Risk
Insurable risks are those pure risks that an insurer is willing to take on because they conform to the main elements of being insurable. These elements include:
- Must have the possibility of an accidental loss, unexpected in exact timing and severity of impact. This is referred to in the insurance industry as “due to chance.”
- Any loss to be covered must be definite and measurable as to the value payable in the event of a loss claim.
- Statistically predictable as to how often a loss is likely to occur and the severity of a loss could be expected to be.
An uninsurable risk is one an insurance company is unwilling to underwrite for a variety of reasons. It may be that a particular risk may be too hazardous for an insurance company to underwrite. An example of this is coverage for floods. If an insurer were to include flood coverage in your standard homeowners’ policy and your home became victim to flood damage, that same type of damage would likely affect everyone’s home in your area. This is known in the insurance industry as a catastrophic loss. Because of this fact, the government must step in to provide you with your flood insurance protection because they know that, otherwise, you would have no flood coverage.
Controllable Versus Uncontrollable Risks
Controllable risks are those over which you have some power to either prevent or mitigate by performing certain actions. An example is the riding of a motorcycle, which for many represents a risky activity. Even if you’re a most capable rider, you have no control over how the other drivers on the road operate their vehicles. You can prevent the risk that’s posed by bike riding by never getting on a bike or you can mitigate the risks by always wearing a helmet and other protective gear, thereby lessening your risk. These are all ways to help control risk.
An example of uncontrollable risk is the potential for your home to be struck by lightning, a tornado, a flood, or other types of natural disasters. While these events may be uncontrollable as to if and when they happen, there are certain things you can to lessen their severity if they do occur. Lightning rods on top of your home and wind-resistant roofing and siding are two examples of this.
Homeowners’ Insurance Risk
Each type of insurance is concerned with its own type of insurance risk. When an insurance underwriter is considering writing you an insurance policy, they will take into account the different risks you face for which the insurer is agreeing to provide indemnity. The cost of the particular policy you are seeking will depend on three factors:
- The possibility that a certain risk for which you’ll be covered will be realized
- The severity of the damage that will occur if a risk is realized
- The total number of risks your insurer is agreeing to cover in the policy
The greater the number of insurance risks covered in a policy, the potential severity of any of these risks is realized, and the possibility that any of these risks could occur will all factor into setting the premium amount for a particular policy. The more perils covered, the greater their possibility of occurring, and the greater the potential severity, if they are realized, translates into higher premium costs.
Standard homeowners’ insurance is designed to protect against a great number of risks, each of which will be spelled out in the policy wording. It covers a long list of perils that can affect your home such as fire, storm damage, lightning, explosions, vandalism, falling objects, and more. It also protects the personal property you have within your home and even your personal possessions lost, stolen, or damaged outside your home. You’re covered for liability claims if someone should get killed or injured while on your property and it even provides financial protection if your dog gets out and bites someone.
Special Insurance Risks
Other factors that will be considered by your homeowners’ insurance policy provider will include special risks. Examples of this may be if your home is in an area that’s seen a number of losses due to wildfires or if your home is in a neighborhood where vandalism or theft is above the acceptable norm. These homes are considered to carry higher risk and your insurer will likely charge a higher coverage cost.
The risks that exist when you’re buying homeowners’ coverage are determined by your insurance underwriter using a variety of methods, including a thorough home inspection. New policy applicants will almost always be subject to a home inspection, which can provide a great means for you to learn the true condition of your home.