Key Takeaways
- Pure risk involves only the possibility of loss or no loss — this is the ONLY type of risk insurance companies will cover
- Speculative risk involves the possibility of loss, gain, or breaking even (like gambling or investing) — NOT insurable
- Static risks are predictable and measurable (theft, fire), while dynamic risks change with economic conditions (unemployment, inflation)
- Fundamental risks affect large populations (earthquakes, war), while particular risks affect individuals (car accident, house fire)
- There are six requirements for an insurable risk: large number of exposures, accidental loss, determinable loss, non-catastrophic, calculable probability, economically feasible premium
Types of Risk
Not all risks are created equal — and more importantly, not all risks are insurable. Understanding how risks are classified is essential for the P&C exam.
Pure Risk vs. Speculative Risk
This is the most important distinction for insurance:
| Risk Type | Definition | Possible Outcomes | Insurable? |
|---|---|---|---|
| Pure Risk | Only possibility of loss or no loss | Loss OR No Loss | YES |
| Speculative Risk | Possibility of loss, gain, or break-even | Loss, Gain, OR Break-even | NO |
Exam Key Point: Insurance companies ONLY cover pure risks. If a question asks which type of risk is insurable, the answer is always pure risk.
Pure Risk Examples
- Death, illness, disability
- Fire destroying a building
- Auto accident causing injury
- Theft of property
- Liability lawsuit
Speculative Risk Examples
- Gambling at a casino
- Stock market investments
- Starting a new business
- Real estate speculation
- Currency trading
Why the Difference? Insurance is designed to restore you to your pre-loss position (indemnification), not to create profit opportunities. Speculative risks involve potential gain, which contradicts the fundamental purpose of insurance.
Static Risk vs. Dynamic Risk
| Risk Type | Characteristics | Insurability | Examples |
|---|---|---|---|
| Static Risk | Predictable, measurable, doesn't change with economy | Generally insurable | Fire, theft, windstorm, death |
| Dynamic Risk | Changes with time and economic conditions, less predictable | Generally NOT easily insurable | Inflation, unemployment, technological change, consumer preference shifts |
Static risks are easier to insure because:
- Historical data is available
- Law of Large Numbers applies
- Premiums can be accurately calculated
Dynamic risks are difficult to insure because:
- They're unpredictable
- Affect large numbers simultaneously
- No reliable historical data for pricing
Fundamental Risk vs. Particular Risk
| Risk Type | Impact Scope | Examples |
|---|---|---|
| Fundamental Risk | Affects large populations; not under individual control | Earthquakes, hurricanes, war, economic recession, inflation |
| Particular Risk | Affects specific individuals or organizations | Car accidents, house fires, personal theft, slip-and-fall injuries |
Insurance Implications
-
Fundamental risks may or may not be insurable
- Flood is NOT insurable by private insurers (covered by federal NFIP)
- Earthquake requires special coverage
- War is excluded from almost all policies
-
Particular risks are usually insurable because they:
- Affect individuals randomly
- Don't cause mass simultaneous losses
- Allow diversification of risk
Six Requirements for an Insurable Risk
For a risk to be considered ideally insurable by private insurance companies, it should meet these six criteria:
1. Large Number of Exposure Units
The insurer needs many similar exposures to predict losses accurately using the Law of Large Numbers.
Example: Auto insurers insure millions of drivers, making accident rates predictable.
2. Accidental and Unintentional Loss
The loss must be:
- Fortuitous (by chance)
- Outside the control of the insured
- Not deliberately caused
Why? Intentional losses create moral hazard and undermine the insurance concept.
3. Determinable and Measurable Loss
Losses must be:
- Definite in time
- Definite in place
- Definite in amount
Why? The insurer must be able to verify the loss occurred and calculate the payment.
4. Non-Catastrophic Loss
Individual losses should not be so severe or widespread that they:
- Bankrupt the insurer
- Affect too many insureds simultaneously
Example: This is why flood insurance isn't offered by private insurers — one flood can affect thousands of policies at once.
5. Calculable Chance of Loss
The probability of loss must be:
- Estimable based on historical data
- Predictable enough to set accurate premiums
Why? Without predictable loss rates, insurers can't price coverage accurately.
6. Economically Feasible Premium
The premium must be:
- Affordable relative to the risk
- Low enough that people will buy it
- High enough to cover expected losses + expenses
Why? If insurance costs more than the potential loss, no one will buy it.
Summary: Risk Classification Chart
An investor purchases stock hoping the price will increase. This is an example of:
Why is flood insurance typically NOT available from private insurers?
Which of the following is a pure risk?
1.3 Principles of Insurance
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