In the insurance industry, "risk" has two specific meanings:
Probability of Loss: The potential for loss, damage, injury, or liability.
Example: "I am going to risk investing in that company."
Insured Item: The item being insured.
Example: "The insured risk is the house of a property owner."
Combining the terms: "ACME insurance is willing to risk insuring the risk."
First use: risk meaning the potential for financial loss.
Second use: risk defines it as the insured item.
Classification of Risk
Insurers classify risk into two categories:
Speculative Risk:
Cannot be insured.
Involves the possibility of both gain and loss.
Undertaken with uncertainty of outcome.
Examples: Buying a lottery ticket, investing in the stock market.
Pure Risk:
Can be insured.
Involves the possibility of loss or no loss, but no possibility of gain.
Does not violate the principle of indemnity.
Aligns with the principle of indemnity, which states that the insured should be restored to their approximate financial condition before the loss but cannot profit from it.
Pure Risks: Insured Entities
Insurers cover pure risks, which include:
Persons
Items
Organizations
Exposure
Exposure is an Insured item's openness, or vulnerability, to loss or damage.
Example: A house built on the Gulf Coast has high exposure to hurricane damage.
Example: A car in a high-crime area has high exposure to theft.
Insurers approximate a risk's exposure in units or dollars to determine the premium.
Underwriting
Insurers evaluate exposure to approximate the premium.
Underwriters determine the probability of loss using actuarial statistics.
The goal is for actual losses to match expected losses, allowing the insurer to protect insureds from catastrophic losses while operating at a profit.
Underwriters evaluate an applicant's risk and exposure to determine if they fit in a similar pool of insureds with an acceptable loss probability.
The underwriter may:
Reject the application protecting the insurer from unnecessary risk.
Accept it in exchange for a higher premium.
Hazard
A hazard is any circumstance that increases the chance of loss.
Can be physical, moral, or morale (to be covered later).
It is a physical or non-physical condition that directly or indirectly increases the likelihood or severity of a loss.
Example: Storing explosives in a basement.
Example: Hot tub increasing exposure to damage or liability.
Example: Flammable liquids stored in a closet.
Exposure: The possibility of loss expressed in dollars or units.
Hazard: A condition that may increase the exposure.
Peril
Peril is the actual cause of a loss.
Examples: Lightning, fire, theft, flood.
Another name for a covered peril is an insurable event.
Insurance policies protect against perils in two ways:
Named Peril Policy: Lists every peril that it covers.
All Peril Policy: Covers all causes of loss except those specifically excluded.
Loss
Loss occurs when the value of an insured item is reduced by a covered peril, or when expenses have to be paid because of an incident.
To an insurer, loss is the amount paid out after a claim has been settled.
Example: Dan wrecked his car and broke his wrist. The car's damage and Dan's medical bills are losses. The insurer indemnifies Dan, and the amount paid is the insurer's loss.
Summary of Terms
Risk:
Potential for financial loss.
The insured item.
Speculative Risk: Cannot be insured; involves the possibility of gain.
Examples: Gambling, investing in businesses, buying lottery tickets.
Pure Risk: Can be insured; involves only loss or no loss.
Exposure: Likelihood of being damaged or lost; vulnerability to damage.
Hazard: Increases the possibility of damage or loss; can be a condition or behavior.
Examples: Smoking, storing flammable materials, swimming pools, nearby rivers prone to flooding, or high crime neighborhoods.