People are exposed to risk every day. They can manage it in various ways: they can avoid the risk, they can reduce the risk, they can share the risk with others, or they can simply do nothing and retain the risk. However, many people reject these risk-management approaches in favor of transferring their risks to an insurance company, through the purchase of various types of insurance.
An insurance policy issued to transfer risk from an individual or entity to an insurance company is subject to the laws that normally govern all contracts. Thus, the formation of a valid insurance contract requires an offer, its acceptance and the payment of consideration (referred to as a premium).
Although an insurer may transact insurance without agents, the overwhelming majority of insurance is purchased through insurance agents. Scaringi Financial Services, LLC employs agents licensed in Pennsylvania to transact insurance business. Those insurance agents, or producers, when acting within their authority, are able to bind insurers. While much of the authority that agents possess is specifically granted by the agency contracts they enter into with insurers, agents may possess far more authority than is specified in the agency contract or intended by an insurer.
Risk refers to the possibility, chance, or probability that an event will occur. Depending on how the term “risk” is applied, it may have any one of various meanings. For example, it can refer to the possibility that a debtor will be unable to repay a loan and interest due; this is “credit risk.” Or it can be applied to the chance that the value of the stock an individual just purchased will decline; this is “market risk.”
In the insurance context, risk is:
- the risk of death—mortality risk—when used in connection with life insurance
- the risk of becoming ill—morbidity risk—when applied to health insurance
Types of Risk
There are two fundamental types of risk: one may be insured against while the other may not—it is “uninsurable” risk.
Speculative risk—a risk that may result in either a loss or a gain. When a person invests in the stock market, for example, there is the possibility the investment will gain value or that it will lose value. Similarly, when a person bets on a horse race, there is the possibility that the horse will win or that it will lose the race.
Pure risk—a risk that does not include the possibility of gain, only a possibility of loss or of no loss. The only outcomes of a pure risk are unfavorable or neutral. An example of pure risk is the chance that one’s home will be damaged or lost due to fire or lightning.
While speculative risk is every bit as real as pure risk, only pure risks can be insured. Speculative risk cannot be insured against, i.e., it is “uninsurable”.
Those faced with a risk—whether individuals or businesses—may have various options available to manage the risk. Accordingly, an at-risk person or business may manage the risk through:
Many risks to which individuals are subject can be avoided. For example, if someone wants to ensure he or she will never be injured or killed in an aircraft accident, that person would never fly. The key to this risk-management technique is clearly to avoid those situations that could result in loss exposure. In many cases, however, a person’s exposure to risk is an integral part of life, and the job of leading a normal life inevitably means being subject to certain risks. Being alive, in and of itself, presents the risk that a person could get sick or could die.
Just as not all risks can be avoided—the risk that we will die someday and may become ill along the way, for example—some risks may reasonably be retained. Suppose a person assesses a risk to which she is subject and concludes that:
- The likelihood of its occurrence is low—a person is young and healthy and believes he will not get sick or will not die
- The resulting financial consequences are negligible, even if the risk becomes reality—a person has no family or assets to protect
In such cases, it could be reasonable for the person to do nothing and simply retain the risk. Still, everyone will experience consequences of sickness or death—you must be cared for and have your affairs taken care of.
The method of reducing a risk to which a person is exposed varies depending on the nature of the risk. For example, a person could reduce the risk of being assaulted by taking a self-defense class. Likewise, managing one’s body weight and food intake may be appropriate ways to reduce the possibility of becoming diabetic. Or, a homeowner may add flame-retardant materials or install smoke alarms to his house to reduce the likelihood of loss by fire. The risk is still present—a thin person can still develop diabetes, for example—but the chances that the risk will become reality may be substantially reduced.
Sharing the risk among similarly situated persons is another method of risk management. Risk sharing has been practiced for centuries. It is known to have occurred in Renaissance Italy among merchants who were shipping their finished goods to buyers throughout the Mediterranean region. Frequently losing cargoes to pirates and uncertain weather, merchants banded together and mutually agreed to bear a share of each shipped cargo that was lost. In so doing, they guaranteed that no individual merchant would be bankrupt from the loss of a single vessel. A somewhat similar but more modern version of risk sharing occurs among certain religious communities. In such communities, a house, barn, or other structure lost by a member of the community through fire, storm, or other accident may be rebuilt by the community members, often just weeks following the loss.
Certain risks—risks considered to be insurable risks—may be transferred to an insurance company by purchasing insurance. In fact, insurance—regardless of whether it is life insurance, health insurance, property insurance, or some other type of insurance—is all about managing risk and transferring its financial consequences to the insurance company. Scaringi Financial Services, LL can help you manage your risks through risk transfer by facilitating purchase of various insurance policies. By purchasing insurance, an individual (or business or other entity) replaces the financial consequences of risk with a smaller known premium payment.
For a risk to be insurable it must be a “pure” risk rather than a speculative risk. An insurable risk must pose only the chance for loss. However, not all pure risks are insurable. For a risk to be insurable, it must not only be a pure risk, it must also meet certain criteria:
- The risk must be such that an insurer is able to charge a premium adequate to pay claims, cover its costs, and make a profit. This means that:
- the loss must be predictable to calculate an appropriate premium
- the loss must not be catastrophic since catastrophic losses would bankrupt an insurer
- the number of loss exposures must be sufficiently large to determine premium adequacy and loss predictability
- The loss must be definite and its value measurable so that a proper claim amount may be determined and paid.
- The loss must be fortuitous—that is, due to chance, unforeseen, and unanticipated. (Although the risk of death is certain, the date of death is normally a random factor.)
Risks that fail to meet any of the listed criteria are not insurable.
Before an insurer agrees to assume a risk it normally goes through a risk-selection process referred to as underwriting. Underwriting determines if the risk proposed for insurance should be accepted or rejected. An important function of the underwriting process is to enable the insurer to avoid adverse selection. Adverse selection refers to the tendency of persons more likely to suffer a risk and have a claim to buy and keep insurance. For example, a person with a serious illness might be much more likely to buy health insurance and to keep it in force than a healthy person.
As you can surmise the greater the possibility of adverse section the higher of a premium the insurance company will charge. For this reason, it is always best to lock in a premium long before the insurance is needed, such as buying life insurance when young even though the possibility for a claim is still far in the future.