0.18) Differentiate between and speculative risk and Non insurable risk as both of these are not guaranteed into
business. Why?
(6 marks
Answers
Answer:
Speculative risks involve the possibility of loss and gain. Pure risks involve the possibility of loss only.
Answer:
Not every risk is insurable. And while insurance is designed to help protect against the many risks of loss associated with running a business, it has never been intended to cover everything.
First, let’s take a moment to define “risk.” There are many definitions, but for our insurance purposes, risk predominantly means two things: uncertainty arising from the possible occurrence of an event(s) and the potential for injury or damage to persons or property to which an insurance policy relates.
Just like your business, insurance companies need to turn a profit in order to survive. That’s why they only agree to cover risks that they deem to be insurable—risks that allow them to yield a profit. In the most basic terms, an insurer will deem a risk insurable only if it is able to charge a premium that covers possible claims and operating expenses while making a profit.
That said, the risks that a business can transfer to an insurance company or more appropriately, chooses to transfer, are generally those that could result in significant loss to the business. Now, let’s take a closer look at how those risks are considered and classified.
Pure Risk vs. Speculative Risk
Insurance companies typically cover pure risks. Pure risks are risks that have no possibility of a positive outcome—something bad will happen or nothing at all will occur. The most common examples are key property damage risks, such as floods, fires, earthquakes, and hurricanes. Litigation is the most common example of pure risk in liability. These risks are generally insurable.
Speculative risk has a chance of loss, profit, or a possibility that nothing happens. Gambling and investments are the most typical examples of speculative risk. The traditional insurance market does not consider speculative risks to be insurable.
In addition, other types of business risks are deemed uninsurable based on the potential that a loss will occur outweighing the potential that it won’t. For example, deterioration of property caused by wear and tear (because a decision was made to not maintain the property in question) or income loss due to market changes are typically not insurable. Risk of loss here may be avoided, or at least mitigated, with proper “controls” in place.
defining insurable risks for businesses illustration
Defining Insurable Risks for Businesses
How do insurers make the distinction when deciding which risks they are willing to assume and which they would rather avoid? Here’s a look at some of the key characteristics that define an insurable risk:
Not Catastrophic
Losses need to be deemed “reasonable” by the insurer. What does that mean? Remember that insurers need to turn a profit to stay in business. Therefore, the level of what each insurer believes is catastrophic will differ. In short, 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.
Don’t confuse this for catastrophe perils, however. 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.