Most insurance companies only cover pure risks, which include most or all of the main parts of an insurable risk. These are examples of large loss exposure, random selection, lack of catastrophic exposure, and chance.
Speculative risk vs. pure risk
Most of the time, insurance companies only cover pure risks, also called event risks. A pure risk is any uncertain situation where the chance of losing money is present, but the chance of making money is not.
Speculative risks, like business ventures or gambling, could make you money or lose you money. Speculative risks don’t have the main things that make them insurable, so they are rarely covered.
Pure risks include natural disasters like fires or floods, as well as accidents like car crashes or serious knee injuries to an athlete. Most pure risks can be put into three groups: personal risks that affect the insured person’s ability to make money, property risks, and liability risks that cover losses caused by social interactions. Private insurers do not cover all pure risks.
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As a Result
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.
This is usually called “due to chance” in the insurance industry. Insurers only pay out claims for losses caused by accidents, though this definition may change from state to state. It protects against things like a landlord burning down their building on purpose.
Specificity and Measurability
For a loss to be covered, the policyholder must show clear proof of loss, usually a bill for a certain amount. If the size of the loss can’t be calculated or fully determined, it isn’t covered by insurance. Without this information, an insurance company can’t generate a fair premium cost or benefit amount.
Statistics Can Tell You
Insurance is a game of statistics, and insurance companies need to be able to guess how often and how bad a loss might be. For example, companies that sell life and health insurance use actuarial science and tables of deaths and illnesses to estimate how much money they will lose across a population.
Not a disaster
Standard insurance doesn’t cover risks that could be very bad. It might seem strange to see an exclusion for catastrophes as one of the main parts of insurable risk, but it makes sense when you look at how the insurance industry defines catastrophic, which is often shortened to “cat.”
Two kinds of risks could be very bad. The first is when all or many units in a risk group, like policyholders in that class of insurance, are exposed to the same event. This type of risk includes things like nuclear fallout, hurricanes, and earthquakes.
The second type of catastrophic risk is any large loss of value that neither the insurer nor the policyholder could have seen coming. The terrorist attacks on Sept. 11, 2001, may be the most well-known example of this terrible thing.
Some insurance companies focus on catastrophic insurance, and many sign reinsurance agreements to protect themselves against disasters. Investors can even buy “cat bonds,” risk-linked securities that raise money for transferring catastrophic risks.
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Large Loss Exposure and Randomly Chosen
The law of large numbers is how all insurance plans work. This law says there must be a large enough number of exposures to an event that are all the same for a reasonable prediction of the loss.
The number of exposure units, or policyholders, must also be big enough to include a statistically random sample of the whole population. This is meant to stop insurance companies from spreading the risk only among the people who are most likely to file a claim, which is what could happen with adverse selection.
In conclusion
Other, less important, or more obvious parts of risk 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 party must agree on the risk. This is also one of the most important parts of a legal contract in the United States.
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