Insurance companies often only back “pure risks,” or those that exhibit all the hallmarks of insurability. These components are “due to chance,” definiteness and measurability, statistical predictability, lack of catastrophic exposure, random selection, and large loss exposure.
Pure Risk vs. Speculative Risk
Most of the time, insurance companies only cover pure risks, also called event risks. A pure risk is any uncertain situation in which the chance of losing money is present but the chance of making money is not.
Speculative risks are those that could make you money or lose you money, like business projects or gambling. Speculative risks don’t have the main things that make them insurable, so they are almost never covered.
Pure risks include natural disasters like fires or floods, as well as accidents like a car crash or a major knee injury to an athlete. Most pure risks can be put into three groups: personal risks that affect the covered person’s ability to make money, property risks, and liability risks that cover losses caused by social interactions. Private insurers do not cover all risks that are pure.
Due to Chance
A risk that can be insured must have a chance of accidental loss. This means that the loss must be caused by something that wasn’t planned and that its exact timing and effects must be a surprise.
In the insurance business, this is often called “due to chance.” Although this definition may vary from state to state, insurance companies only pay claims when an accident was the cause of the loss. It protects against things like an owner burning down their own building on purpose.
Definiteness and Measurability
For a loss to be covered, the insured must be able to show a clear proof of loss, which is usually a bill for a certain amount. If it is impossible to estimate or fully determine the size of the loss, insurance is not applicable. Without this knowledge, an insurance company can’t come up with a fair premium cost or benefit amount.
Statistically Predictable
Insurance is a numbers game, and insurance companies need to be able to make educated guesses about the likelihood of their clients experiencing a loss and the extent of that loss. Actuarial science and mortality and morbidity tables are utilized by companies offering life and health insurance, for example, in order to project the amount of money lost across populations.
Not Catastrophic
Standard insurance doesn’t cover risks that could be very bad. It might seem strange to see an absence of catastrophes as one of the main parts of an insurable risk, but it makes sense when you look at how the insurance industry defines catastrophic, which is often shortened to “cat.”
There are two kinds of risks that could be very bad. The first is when all or many units in a risk group, like policyholders in that type of insurance, are exposed to the same event. This type of risk includes things like nuclear fallout, storms, and earthquakes.
The second type of catastrophic risk is any large loss of value that neither the insurance company nor the policyholder could have seen coming. The terrorist strikes on Sept. 11, 2001, may be the most well-known example of this kind of terrible thing.
Some insurance companies focus on catastrophic insurance, and many insurance companies sign reinsurance deals to protect themselves against disasters. Investors can even buy “cat bonds,” which are risk-linked products that raise money for transferring catastrophic risks.
Randomly Selected and Large Loss Exposure
The law of big numbers is how all insurance plans work. This law says that there must be a large enough number of exposures to an event that are all the same for a fair prediction of the loss to be made.
The number of exposure units, or policyholders, must also be large enough to include a statistically random sample of the whole community. This is meant to stop insurance companies from sharing the risk only among the people who are most likely to file a claim, which is what could happen with adverse selection.
Summary
There are other, less important, or more obvious parts of a danger that can be insured. For example, the risk must lead to hard times financially. Why? Because if it doesn’t, there’s no reason to pay for insurance. Each side must agree on the risk. This is also one of the most important parts of a legal contract in the United States.
