MJN - RISK MANAGEMENT - INTERNATIONAL CLASS - GANJIL 2021/2022

There are no measurable benefits when it comes to pure risk. Instead, there are two possibilities. On the one hand, there is a chance that nothing will happen or no loss at all. On the other, there may be the likelihood of total loss.

Pure risks can be divided into three different categories: personal, property, and liability. There are four ways to mitigate pure risk: reduction, avoidance, acceptance, and transference. The most common method of dealing with pure risk is to transfer it to an insurance company by purchasing an insurance policy. Many instances of pure risk are insurable. Pure risks can be insured because insurers are able to predict what their losses may be.

Insurance is a means of protection from financial loss. It is a form of risk management, primarily used to hedge against the risk of a contingent or uncertain loss. An entity which provides insurance is known as an insurer, an insurance company, an insurance carrier or an underwriter. A person or entity who buys insurance is known as an insured or as a policyholder. The insurance transaction involves the insured assuming a guaranteed and known - relatively small - loss in the form of payment to the insurer in exchange for the insurer's promise to compensate the insured in the event of a covered loss. The loss may or may not be financial, but it must be reducible to financial terms, and usually involves something in which the insured has an insurable interest established by ownership, possession, or pre-existing relationship. The insured receives a contract, called the insurance policy, which details the conditions and circumstances under which the insurer will compensate the insured. The amount of money charged by the insurer to the policyholder for the coverage set forth in the insurance policy is called the premium.

How do insurers make the distinction when deciding which risks they are willing to assume and which they would rather avoid? There are some key characteristics that define an insurable risk: 

Not Catastrophic. Losses need to be deemed “reasonable” by the insurer. 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. Those larger risks can still be insurable, but 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.

Predictability. If an insurer cannot predict expected losses, then they cannot properly quantify potential losses. Insurers, their actuaries, really, prefer a predictable loss in order to be able to determine premiums. If a loss rate is not predictable, it’s less likely to be in that insurer’s “appetite,” meaning they won’t want to take on that type of risk. How, then, do insurers come up with a predictable loss rate? Back to their actuaries, professionals that mathematically, statistically, and financially analyze financial risk by running a plethora of statistical models and analysis. Some of those calculations ultimately boil down to the “law of large numbers,” which is the use of an extensive database used to forecast anticipated losses. Others are far more complex in their modeling. 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.

"Chance" and Random Losses. 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.

Defined and measurable. Losses need to be definite and measurable. The effective and expiration dates on a policy “define” the duration that is then “measured” as to the amount of premium dollars needed to offset projected losses.