Risk Management 101: What Makes Something Insurable by Property & Casualty Insurance?

I have decided to start a “Risk Management 101” series in order to explain some of the basics of risk and risk management.  Obviously I’m biased, but I think you’ll find that risk management is quite interesting.  While risk management encompasses many concepts beyond traditional hazard risks and property & casualty insurance, that is the best place to start with explanations as it is familiar to the most people.

So, you have  some exposure to loss and you want to be able to transfer it to another entity (e.g. pay them to cover a certain amount of potential loss).   In this case, an insurance policy would be a good idea.  However, certain criteria must be met in order for a loss exposure to be insurable.

First, let’s start with some definitions:

Risk:

        The chance of injury, damage, or loss.

• The ISO 31000 defines risk as: the effect of uncertainty on objectives.

Pure Risk

         A risk which only offers the chance of loss occurring.

Hazard Risks:

          Hazard risks are uncertainties associated with a reduction in property value   or the incurring of civil liability damages as a result of an accidental loss.

• Hazard risk involves only the chance of loss, thus it is considered “pure risk” as opposed to “speculative risk.”

Loss Exposures:

 

         Conditions which could result in financial loss to a company from property, personnel, liability, or net income losses.

Insurance:

        A mechanism for contractually shifting burdens of a number of pure risks by pooling them.

• Insurance involves the transfer of hazard risk, and is one of several methods of risk management.
• The purpose of insurance is to spread hazard risk among others with similar loss exposures.

Second, let’s dig deeper into what characteristics a loss exposure must possess in order to be a candidate for insurance.  According to Risk Financing, 4th Ed. (from the AICPCU), the Six Characteristics of an Ideally Insurable Property & Casualty Loss Exposure are (their points, with my comments):

1. Pure Risk: as mentioned above, as opposed to a speculative risk in which there is a chance of loss, a wash, or a gain.
2. Fortuitous Loss:  Fortuitous doesn’t mean fortunate or lucky.  Instead, this means that the loss is accidental.
3. Definite and Measurable:  The insurer needs to know what is being covered, when the loss occurred, and how to quantify the damages caused associated with the loss.
4. Homogenous: The loss exposure should be one of a large number of similar loss exposure units.  This brings the Law of Large Number into play, and it makes loss prediction more accurate.
5. Independent and not Catastrophic:  Insurers write a loss exposure expecting that on a small number of units within a large pool will be experiencing losses at any given time.   This is why an insured can pay a relatively small amount of premium in order to protect a large amount of property or potential liabilities.
6. Affordable:  Nothing tricky here.  Insurers sell policies when there is a market for them.  If policies are too expensive, potential insureds will find other ways to deal with risk.

The above list represents the ideal; however, not all of these elements are completely necessary in order to insure a risk.  People sometimes wonder why a policy has what appears to be a large number of terms, conditions, and exclusions.  The apparent complexity of an insurance policy is in part to address the issues above, and to attempt to achieve as much homogeneity of loss exposure over a large group as possible.  While this may seem complicated, it’s not.

Another way to look at something being insurable is this:

1. You are insuring against loss from certain damage to property or from something negligent you or your company does which results in you being liable to a third party.
2. You are insuring against something accidental.  You didn’t know it was going to happen, and you didn’t purposely cause the damage to occur.
3. The potential causes of loss need to be defined up front, so that the insurer can adequately charge for them.
4. Liabilities need to be defined up front, so that the insurer and the insured know what is covered and what isn’t.
5. The property items or liability amounts need to be address up front, so that the insurer knows what is being covered.
6. Damages need to be measured in the easiest medium possible, currency.  It’s quantifiable, fungible, and can be analyzed.
7. Catastrophes are hard for private insurers to cover, since they have the potential to drain the funds of an insurer.
8. If people/companies can’t afford your coverage, they won’t buy policies.   Insurers can’t run a program if there isn’t any money available to pay for losses.

The above lists illustrate the basic characteristics which allow for insurance to be considered as a risk management device for property & casualty loss exposure.   Another key concept to keep in mind is that the purpose of insurance is to indemnify for loss.  I.e., an insured is not supposed to be enriched by insurance, but rather returned to the condition he/she/it was in prior to the loss occurring.    A more colloquial way to say this would be that insurance is supposed to “make one whole,” as opposed to provide a windfall.

 

There you go.  That’s characteristics of an insurance loss exposure from 30,000′.  Check the category label and keep an eye out for more in this series of Risk Management 101 posts.

 

–Dave Floyd

CEO & General Counsel

Prism Risk Management, LLC