IV.

CHARACTERISTICS OF AN INSURABLE RISK

We have stated previously that individuals see the purchase of insurance as
economically
advantageous. The insurer will agree to the arrangement if the risks can be pooled, but
will need
some safeguards. With these principles in mind, what makes a risk insurable? What
kinds of risk
would an insurer be willing to insure?
The potential loss must be significant and important enough that substituting a known
insurance
premium for an unknown economic outcome (given no insurance) is desirable.
6
The loss and its economic value must be well-defined and out of the policyholder’s
control. The
policyholder should not be allowed to cause or encourage a loss that will lead to a
benefit or claim
payment. After the loss occurs, the policyholder should not be able to unfairly adjust
the value of
the loss (for example, by lying) in order to increase the amount of the benefit or claim
payment.
Covered losses should be reasonably independent. The fact that one policyholder
experiences a
loss should not have a major effect on whether other policyholders do. For example,
an insurer
would not insure all the stores in one area against fire, because a fire in one store
could spread to
the others, resulting in many large claim payments to be made by the insurer.
These criteria, if fully satisfied, mean that the risk is insurable. The fact that a
potential loss does
not fully satisfy the criteria does not necessarily mean that insurance will not be
issued, but some
special care or additional risk sharing with other insurers may be necessary

Insurance is a risk-management tool. However, insurers are in the business of

insurance as a going concern and to make a profit. They are not inclined to insure
every risk that people or entities may face. On the contrary, insurers are quite
discriminating about the risks that they cover and whether they accept the risk of a
particular proposal.

An "insurable risk" is a danger of financial loss that an insurer is willing and able to
cover. Whether a risk is insurable or not is not determined capriciously. There are
eight fundamental characteristics of an insurable risk. If any one of these
characteristics is not present, an insurable risk becomes uninsurable.
 1) Uncertainty

The timing of the loss cannot be expected. Even in the case of life insurance- where
death is expected- the timing of death is the subject of speculation. Therefore, if a loss
is expected (terminal illness/hurricane warning) or forecasted otherwise, the risk
would most likely not be insurable.

2) Capricious

As far as the policy owner is concerned, the loss must not happen by chance or be
predictable. It would be alright if someone is planning to burn down your home. If an
insurer is aware that you have knowledge of this; the risk will be uninsurable. This
also suggests that the policy owner cannot intentionally cause the loss- whether
directly or indirectly.

3) Determinable risk

An insurer must be able to apply methods and techniques to determine the likelihood
of the loss. Where life insurance is concerned, this is based on risk groups and health
information, among other factors. With home insurance, underwriting factors like
location and market value are significant. Insurance involves a lot of actuarial work.

4) Sufficiently large market for that risk

If there are not enough people in the market for a particular type of insurance, then the
risk would not be spread over a large enough segment. This means that the likelihood
of an underwriting loss may be to great for the risk to be insurable.

5) Reasonable cost

Premiums for an insurable risk should not be prohibitive; otherwise people would not
be willing or able to purchase the insurance.

6) Significant loss

Insurance was not designed to cover expenses that people could easily cover for
themselves. If this were the case, then premium rates would be significantly higher.
This is the basis for advising people not to take insurance for losses that their finances
could easily withstand. The policy owner bears the additional risk through higher
premiums. This is why having higher deductibles reduces insurance premiums as
well.

7) The risk must not be financially catastrophic

An insurer is highly unlikely to cover a risk that could result in substantial losses that
may render the insurer insolvent. For losses that are substantial, insurers pass on some
of the burden to reinsurers who bear part of the risk. The mechanism of reinsurance
actually allows several otherwise catastrophic risks to become insurable. Particularly
in the realm of commercial insurance, the financial risk of loss can be quite high.
 8) The loss must be certain where time and amount are concerned

Simply put, the insurer should be able to answer two basic questions:
i) When am I required to pay policy benefits?
ii) How much am I required to pay?

Using these principles, it may be easier to understand (although not accept) why
certain risks cannot be covered. For instance, someone seeking life insurance- having
suicidal intentions- would violate the characteristic that the loss should not be
intentionally caused by the policy owner. Also, a company seeking 1 billion dollars in
commercial coverage may also be refused coverage, if this loss is deemed too
catastrophic for an insurer. These characteristics of insurable risks are for the benefit
of the insurer and, in some cases, the insur