Orlando Harmon
When it comes to insurance, not every risk is insurable. Insurers need to be able to calculate two types of losses: actual losses and expected losses. Losses must be the result of an unintentional act or one that occurred by chance, be beyond the control or influence of the business, and be random. Pure risks, such as property damage, are typically covered by insurance companies, while speculative risks, such as those related to gambling or investing, are not.
| Characteristics | Values |
|---|---|
| First Type of Loss | Actual losses |
| Second Type of Loss | Expected losses |
| Who calculates the losses | Insurers |
| Insurers calculate losses to | Estimate how often particular losses might occur |
| Estimate the expected severity of these losses | |
| Insurable loss | Loss must be the result of an unintentional act or one that occurred by chance |
| Loss must be random | |
| Loss must be measurable and definite | |
| Loss must be predictable | |
| Loss must not be catastrophic | |
| Loss must have large loss exposure |
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Actual losses
Insurers must calculate two types of losses: actual losses and expected losses. This response will focus on actual losses.
Insurers need to verify these actual losses before agreeing to pay out damages. This verification process usually involves the policyholder submitting proof of loss, often in the form of bills or receipts. By examining these documents, insurers can ascertain the extent of the financial loss and determine whether the claim falls within the scope of the insurance policy.
It's important to distinguish between actual losses and expected losses. Expected losses, also known as insurable risks, are potential future losses that insurers try to predict and quantify. These predictions are based on statistical models and analysis, and they help insurers set premiums at a level that ensures profitability. Expected losses are inherently uncertain, as they involve forecasting the likelihood and severity of future events.
In summary, actual losses refer to financial losses that have already been incurred by the insured and are typically verified by insurers through proof of loss documentation. These realised losses are distinct from expected losses, which are based on probabilistic assessments of future events. Understanding and managing both types of losses are crucial for insurers to maintain their financial viability and effectively serve their clients.
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Expected losses
Insurers must calculate two types of losses for their clients: actual losses and expected losses. Expected losses are those that are deemed insurable and are calculated by actuaries, who mathematically, statistically, and financially analyse financial risk by running a range of statistical models and analyses. Some calculations are based on the law of large numbers, which uses a large database to forecast anticipated losses. Other models are far more complex.
In essence, insurers need to estimate how often particular losses might occur and the expected severity of these losses. Losses that occur more frequently and are more severe will result in higher premiums. For a loss to be insurable, it must be the result of an unintentional act or one that occurred by chance, beyond the control or influence of the business. Losses must also be random, meaning the potential for adverse selection does not exist.
Insurers also need to be aware of catastrophic risks, which involve unpredictably large losses not anticipated by either the insurer or the policyholder. Some insurance companies specialise in catastrophic insurance, and many enter into reinsurance agreements to protect against such events.
It is important to note that not all risks are insurable, and insurance is designed to cover only those risks that allow insurers to yield a profit. Insurers will only cover risks that they deem insurable, i.e., those that enable them to charge a premium that covers possible claims and operating expenses while generating a profit.
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Pure risks
Insurers must calculate actual losses and expected losses. Pure risks are those that are "due to chance", definite and measurable, statistically predictable, non-catastrophic, randomly selected, and with large loss exposure. Pure risks are insurable, and most insurers will cover these, as opposed to speculative risks. Pure risks include property damage and certain kinds of litigation. They are beyond the control or influence of the business or policyholder and are unintentional. For example, a natural disaster is a pure risk as it is a chance event that results in economic hardship.
Insurers will only cover pure risks if they are insurable, meaning they meet the criteria of being beyond the control of the policyholder, unintentional, and random. They must also result in economic hardship, otherwise, there is no incentive to insure against the loss.
Insurers will also not cover catastrophic events, which are unpredictable and affect large numbers of people or property. Some insurance companies specialize in this area, however, and reinsurance agreements are often made to guard against such events.
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Insurable risks
For a risk to be insurable, the loss must be the result of an unintentional act or one that occurred by chance, beyond the control or influence of the business. For example, insurance companies typically cover pure risks, such as property damage, and certain kinds of litigation.
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Uninsurable risks
Insurers must calculate actual losses and expected losses. However, uninsurable risks are those that pose an unknowable or unacceptable risk of loss or a situation in which providing insurance would be against the law. These are risks that are very likely to result in a loss, and insurance companies limit their losses by not taking on such risks. For instance, a flood in an area where flooding is frequent is an uninsurable risk. Similarly, a marriage failing cannot be insured because there are too many factors at play for an actuary to calculate a definitive probability of success or failure.
Some other examples of uninsurable risks include criminal penalties, natural disasters in areas prone to such disasters, reputational risk, regulatory risk, trade secret risk, political risk, and pandemic risk. While some coverage is available for these risks, it is often limited and expensive.
Risk managers play a crucial role in identifying and managing organizational exposures to uninsurable risks. While commercial insurance can sometimes be used to mitigate these risks, it is not always possible, and companies may need to find alternative ways to hedge against these risks.
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Frequently asked questions
Insurers must calculate actual losses and expected losses.
An actual loss is a loss that has already occurred. Insurers need to calculate the severity of the loss to determine how much money they need to pay out.
An expected loss is a prediction of how often a particular loss might occur and the expected severity of these losses. Insurers use statistical models and analysis to forecast anticipated losses.
Insurable risks are typically pure risks, which are due to chance, definite and measurable, statistically predictable, non-catastrophic, randomly selected, and involve large loss exposure. Examples include property damage and certain kinds of litigation.
