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The Insurability of Risk

By Ade Fashola

It was a Sunday morning, exactly two days after the “Ileya” Festival, Femi came to my house and started the conversation on insurability of risk. I asked Femi, “Are you still with your insurance note?” He replied “Yes, right here.” He brought out the note from his bag. Promptly, I resumed my training session with him. I made him sit down and went on.

“Femi, not all risks are insurable and if you will be patient, I will take my time to explain the characteristics of insurable risk.”

“Insurable risk”? Femi repeated

“Yes, insurable risk”. I retorted and continued “There is also uninsurable risk. Uninsurable risk is a condition that poses an unacceptable risk of loss or a situation in which the insurance would be against the law. Insurance companies limit their losses by not taking on certain risks that are very likely to result in a loss. Let me put it this way, there are pure and speculative risks.

Insurance companies typically cover pure risks. Pure risks are risks that have no possibility of a positive outcome meaning something bad will happen or nothing at all will occur. For example; floods, fire, accident, earthquakes, and hurricanes. Litigation is the most common example of pure risk in liability. Pure risks are generally insurable. Speculative risk has a chance of loss, profit, or a possibility that nothing happens. Gambling and investments are the most typical examples of speculative risk. The traditional insurance market does not consider speculative risks to be insurable. Furthermore, types of business risks are deemed uninsurable based on the potential that a loss will occur outweighing the potential that it won’t. For example, deterioration of property caused by wear and tear due to neglect or income loss due to market changes are typically not insurable. Risk of loss here may be avoided, or at least mitigated if proper control is put in place.”

Femi sighed then asked “how do insurers make the distinction between the risks to assume and which they would rather avoid?” I replied, “let me now explain the characteristics of insurable risks. The risk must be fortuitous, meaning it must be accidental, outside the control of the beneficiary. Loss must be the result of an unintentional act or one that occurred by chance in order to be insurable. In essence, it must be beyond the control or influence of the business. Losses also need to be random, meaning that the potential for adverse selection does not exist. Adverse selection describes situations in which buyers and sellers have access to different information and market participation is affected as a result of this so-called state of asymmetric information.

Secondly, Losses must be definite and measurable meaning that must be identifiable and in order to be calculated; loss must take place at a range of defined time, in a known place and from a known cause. The effective and expiration dates on a policy must be defined and the duration is measured as to the amount of premium payable to offset projected losses.

Thirdly, Impending Loss Must be Large enough to warrant insurance cover. Simply put, the size of the loss must be meaningful from the perspective of the insured for him or her to seek for insurance protection. Also, such exposure should affect a large number of people. You need premium from a large number of policy holders to offset the losses of the few. Insurance operates through pooling of resources; many contributing to cater for the misfortune of few.

Fourthly, the probability of loss, and the attendant cost must be calculable. If an insurer cannot predict expected losses, then they cannot properly quantify potential losses. Insurers through the actuaries, really prefer a predictable loss in order to be able to determine premiums. If a loss rate is not predictable, it is less likely for insurer to accept such risk meaning that the underwriters may not want to take on that type of risk. It is this process that make the premium affordable and equitable. The price or cost payable for cover should be minimal and equitable compared to amount at risk or benefits or claims payable.

Furthermore, the loss must be non-catastrophic. Losses must not happen to all insured at once. Losses need to be deemed “reasonable” by the insurer.”

“What does that mean?” Femi asked again.

I continued, “remember that insurers need to cover their cost and make a profit to stay in business” He nodded. “Therefore, the level of what each insurer believes is catastrophic will differ. In short, a catastrophic risk for an insurance company is any type of loss that is so pervasive, expensive, or unpredictable that it would not be reasonable to offer coverage for it. There are differences between catastrophic losses and catastrophic perils, those larger risks can still be insurable mostly by insurers who believe that they can appropriately quantify its potential for loss and charge appropriate premiums to do so. Catastrophe perils may include such natural disasters as earthquakes, hurricanes, and acts of war.”

Femi had that processing look in his eyes as he raised another question “how, then, do insurers come up with a predictable loss rate?” I then explained that Insurers are backed by actuaries, who are professional mathematicians or statisticians that can use modelling to analyze financial risk by running a plethora of statistical models and analysis. Some of those calculations ultimately boil down to the use of large number with the use of an extensive database used to forecast anticipated losses and resolve complex exposure. Simply stated, insurers need to be able to estimate how often particular losses might occur and what the expected severity of these losses could be. Naturally, losses that occur more frequently and tend to be more severe will drive higher premiums.

“ I didn’t know insurance is this complex” Femi asserted.

“No, it is not complex, insurance has its own principle and practice which are the rules governing its operations” I replied.

Ade Fashola is the CEO of Universal Risk

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