Principles of Risk and Insurance

Understanding the fundamental principles of risk and insurance is essential for CFP candidates. These concepts form the foundation for all insurance planning decisions and appear frequently on the CFP exam. This section covers the classification of risk, the mathematical principles that make insurance possible, and the legal doctrines that govern insurance contracts.

Pure Risk vs. Speculative Risk

Risk classification is a fundamental concept in insurance planning. Financial planners must understand the difference between pure risk and speculative risk to advise clients appropriately.

Pure Risk

Pure risk is a situation where there are only two possible outcomes: loss or no loss. Pure risk never offers the possibility of gain. Examples include:

• Premature death of a wage earner
• Disability that prevents someone from working
• Property damage from fire, flood, or theft
• Medical expenses from illness or injury
• Liability from accidents causing harm to others

Pure risks share several characteristics:

• They are uncontrollable—the individual cannot choose to create gain from the situation
• They typically involve chance occurrences rather than deliberate actions
• They are generally insurable because outcomes can be predicted statistically

Speculative Risk

Speculative risk is a situation where three outcomes are possible: loss, no change, or gain. Speculative risks involve voluntary choices where the individual hopes to profit. Examples include:

• Investing in the stock market
• Starting a new business venture
• Gambling at a casino
• Real estate speculation
• Commodity trading

Speculative risks are generally not insurable because:

• The individual voluntarily assumes the risk hoping for gain
• Outcomes are influenced by skill, knowledge, and market conditions
• Moral hazard would be extreme if people could insure against investment losses

Exam Tip: Risk Classification

The CFP exam frequently tests your ability to classify risks. Remember: if there is any possibility of gain, it is speculative risk. Insurance companies only cover pure risks because they can use statistical methods to predict losses. A common exam question presents a scenario and asks you to identify the type of risk involved.

The Law of Large Numbers

The law of large numbers is the mathematical principle that makes insurance possible. This statistical concept states that as the number of similar exposure units increases, the actual results will more closely approximate the expected (predicted) results.

How It Works

When an insurance company insures a small number of homes, the actual losses in any given year may vary dramatically from predictions. One year might have zero fires; another might have several. However, when the company insures millions of homes, the actual fire losses will closely match the predicted average.

Key requirements for the law of large numbers to work:

1. Independence: Each risk must be independent of others. One person's house fire should not increase the likelihood of another's.

2. Homogeneity: The risks must be similar in nature. You cannot combine fire insurance data with flood insurance data to predict either one.

3. Large numbers: The pool must be sufficiently large. Insurance companies need thousands or millions of policyholders to make accurate predictions.

Practical Application

The law of large numbers explains why:

• Insurance premiums can be affordable—spreading risk across millions reduces individual costs
• New insurance products may have higher initial premiums until sufficient data accumulates
• Catastrophic events (earthquakes, hurricanes) are harder to insure—they affect many policyholders simultaneously, violating the independence requirement

Exam Tip: Law of Large Numbers Exceptions

The CFP exam may ask about situations where the law of large numbers does not apply. Catastrophe insurance (floods, earthquakes, pandemics) cannot rely solely on this principle because these events affect many policyholders at once, creating correlated rather than independent losses. Insurers use reinsurance and catastrophe bonds to manage these risks.

Insurable Interest

Insurable interest is a legal requirement that the person purchasing insurance must have a financial stake in the continued existence or well-being of the insured person or property. Without insurable interest, an insurance contract is void.

Purpose of Insurable Interest

The doctrine serves two important purposes:

1. Prevents gambling: Without insurable interest, people could take out insurance policies on strangers, essentially betting on their death or misfortune.

2. Reduces moral hazard: If you have no financial stake in someone's well-being, you might not care—or might even benefit—if harm befalls them.

Insurable Interest in Life Insurance

For life insurance, insurable interest must exist at the time of policy inception. It does not need to exist at the time of claim. This means:

• A spouse can purchase life insurance on their partner even if they later divorce
• A business partner can maintain a policy on a former partner who has left the company
• The beneficiary need not have insurable interest (the policy owner must have it)

Common examples of insurable interest in life insurance:

Insurable Interest in Property Insurance

For property and liability insurance, insurable interest must exist both at policy inception AND at the time of loss. This is a crucial distinction from life insurance.

Examples of property insurable interest:

• Homeowners have insurable interest in their residence
• Landlords have interest in rental properties they own
• Tenants have interest in their personal property and improvements
• Secured creditors have interest in collateral

Exam Tip: Timing of Insurable Interest

This is a frequently tested concept. Remember: Life insurance = inception only; Property insurance = inception AND loss. A common exam scenario presents someone who sells property after purchasing insurance—since insurable interest no longer exists at the time of loss, the claim would be denied.

The Principle of Indemnity

The principle of indemnity states that insurance contracts are designed to restore the insured to the same financial position they were in before the loss—no better, no worse. Policyholders cannot profit from insurance.

How Indemnity Works

If your car worth $20,000 is totaled, you receive $20,000 (minus deductibles)—not more. If your home valued at $300,000 burns down, you receive compensation to rebuild or replace it, not to build a mansion.

Key aspects of indemnity:

Exceptions to Indemnity

Some insurance products do not strictly follow the indemnity principle:

• Life insurance: Pays a stated death benefit regardless of the insured's "value"
• Valued policies: Some states require payment of full policy limits for total losses
• Stated amount coverage: For unique items like jewelry or art

Exam Tip: Indemnity Calculations

The CFP exam may include calculations involving actual cash value versus replacement cost. Remember: ACV = Replacement Cost - Depreciation. If a television cost $2,000 new and is 50% depreciated, the ACV is $1,000, even if a new TV costs $1,500 today (you would receive $750 in this case: $1,500 × 50% = $750).

Subrogation

Subrogation is the right of an insurance company to "step into the shoes" of the insured and pursue recovery from a third party who caused the loss. The term comes from the Latin word "subrogare," meaning to substitute one person for another.

How Subrogation Works

1. Policyholder suffers a loss caused by a third party
2. Insurance company pays the claim to the policyholder
3. Insurance company acquires the policyholder's right to sue the third party
4. Insurance company recovers some or all of the claim payment from the responsible party

Example: Your parked car is hit by a drunk driver. Your insurance company pays to repair your car, then sues the drunk driver to recover the repair costs.

Connection to Indemnity

Subrogation supports the principle of indemnity by preventing the insured from receiving double compensation. Without subrogation:

• The insured could collect from their insurance AND sue the negligent party
• The negligent party might escape financial responsibility
• Insurance costs would increase as companies could not recover payments

Important Subrogation Rules

Exam Tip: Subrogation Scenarios

CFP exam questions often present scenarios where a third party caused damage to insured property. Remember that after the insurer pays the claim, they have the right to pursue the responsible party. If the policyholder settles with the third party before notifying their insurer, they may have violated the policy terms.

Key Insurance Concepts Summary