Table of Contents
1. Concept and Types of Risks
Concept of Risk
Risk is defined as the uncertainty concerning the occurrence of a loss. It is the possibility of an unfavorable deviation from a desired outcome.
Insurance is concerned with Pure Risk, not all types of risk.
Types of Risks
| Type of Risk | Description | Insurable? |
|---|---|---|
| Pure Risk | A situation where there are only two possibilities: loss or no loss. (e.g., a house fire). | Yes. This is the basis of insurance. |
| Speculative Risk | A situation where there is a possibility of loss, no loss, or gain. (e.g., gambling, investing in stocks, starting a business). | No. Insurance does not cover risks taken voluntarily in the hope of gain. |
| Fundamental Risk | A risk that affects a large group of people or the entire economy. (e.g., war, inflation, earthquake). | Generally No. These are often too large or catastrophic for private insurers. May be covered by government. |
| Particular Risk | A risk that affects individuals or specific small groups. (e.g., car theft, house fire). | Yes. These are the primary risks covered by insurance. |
| Dynamic Risk | Risks arising from changes in the economy (e.g., changes in consumer taste, new technology). | No. These are speculative in nature. |
| Static Risk | Risks from perils in nature or dishonesty of individuals (e.g., flood, theft). | Generally Yes. |
2. Managing Risk
Risk Management is the process of identifying, assessing, and controlling threats to an individual's or organization's well-being. There are four main techniques:
- Risk Avoidance:
- What: Actively avoiding the risk.
- Example: Not buying a car to avoid the risk of a car accident. Not getting married to avoid the risk of divorce.
- Drawback: Often impractical or comes with a high opportunity cost.
- Risk Reduction (or Loss Control):
- What: Taking steps to reduce the *frequency* or *severity* of a loss.
- Example: Installing smoke detectors and fire extinguishers (reduces severity of fire), or wearing a seatbelt (reduces severity of injury).
- Risk Retention (or Self-Insurance):
- What: Knowingly accepting the risk and paying for any resulting losses yourself.
- Example: Deciding not to buy insurance for a minor risk, like a cracked phone screen (this is "active" retention). Or, not knowing about a risk (this is "passive" retention).
- Risk Transfer:
- What: Shifting the financial burden of a risk to another party.
- Example: This is the core of insurance! You transfer the risk of a 1,000,000 hospital bill to an insurance company in exchange for a500 premium.
3. Sources and Measurement of Risk
Sources of Risk (Hazards)
A Hazard is a condition that increases the *probability* or *severity* of a loss. They are the sources of risk.
- Physical Hazard: A physical condition that increases the chance of loss.
- Example: A defective wire (fire hazard), an icy road (auto hazard), a cancerous tumor (health hazard).
- Moral Hazard: Dishonesty or a defect in a person's character that leads them to *intentionally* cause a loss.
- Example: Intentionally burning down your own building to collect insurance money (arson).
- Morale Hazard (or Attitudinal Hazard): Carelessness or indifference to a loss because you know you are insured.
- Example: Leaving your car unlocked with the keys inside *because* "it's insured anyway." Not wearing a seatbelt.
Measurement of Risk
Insurers measure risk by considering two factors:
- Frequency (Probability): How likely is the loss to occur? (e.g., 1 in 1000 houses in this area will burn down this year).
- Severity (Amount): How large will the loss be if it occurs? (e.g., the average cost of a house fire is $200,000).
A risk with low frequency but high severity (like a house fire) is the ideal type of risk to insure. A risk with high frequency and low severity (like a papercut) is best managed by risk retention (self-insurance).
4. Risk Evaluation and Prediction
This is the process by which insurers determine if a risk is insurable and what premium to charge.
The Law of Large Numbers (LLN)
This is the statistical principle that insurance is built on.
LLN: As the number of exposure units (e.g., houses, cars) in a group increases, the actual (observed) loss experience will get closer and closer to the probable (expected) loss experience.
- In English: You can't predict if *your* house will burn down this year. But an insurer, by looking at data for 1,000,000 houses, can predict with high accuracy that *around* 1,000 of them will.
- This allows insurers to turn "uncertainty for the individual" into "certainty for the group," which makes the risk predictable and therefore insurable.
Process of Evaluation (Underwriting):
Underwriting is the process of selecting, classifying, and pricing risks. The underwriter must evaluate the risk (e.g., you) to decide if you are a standard risk, a preferred risk (better than average), a substandard risk (worse than average), or an uninsurable risk.
5. Risk pooling and Risk transfer
These are the two fundamental concepts that make insurance work.
Risk Transfer
As covered under risk management, this is the first step. The individual (insured) pays a premium to an insurance company (insurer). In exchange, the insurer agrees to accept the financial risk of a potential loss. The risk has been *transferred* from the insured to the insurer.
Risk Pooling (or Risk Sharing)
This is what the insurer does with all the risks it has accepted.
Risk Pooling: The process of combining all the premiums (from thousands of individuals) into a single "pool." This pool of money is then used to pay for the losses of the unfortunate few who suffer a loss.
In essence, insurance is a system where the losses of the few are shared by the many. The premium paid by each person is their share of the group's total expected losses. This is the "how" risk transfer is made financially viable.