1.2 Risk & Insurance Concepts
Key Takeaways
- Only pure risk (chance of loss or no loss, never gain) is insurable; speculative risk, which includes a chance of gain, is not.
- A peril is the cause of loss; a hazard increases the chance or severity of a loss, and hazards are physical, moral, or morale.
- The law of large numbers lets insurers predict aggregate losses accurately as the insured pool grows.
- For life insurance, insurable interest must exist at the time of application only, not at the time of death.
- Life insurance is a valued contract that pays a stated face amount, not an indemnity contract limited to actual loss.
Risk: The Reason Insurance Exists
Risk is uncertainty about loss. Insurers can only handle one kind of risk.
- Pure risk involves only the chance of a loss or no loss, with no possibility of gain (a person dies or does not). Pure risk is insurable.
- Speculative risk involves a chance of loss, no change, or gain (betting, investing in a stock). Speculative risk is not insurable, because the insured could profit.
Life insurance addresses the pure risk of premature death and the financial loss it causes dependents.
Peril vs. Hazard
These two terms are constantly confused on the exam.
- A peril is the cause of a loss (disease, accident, fire).
- A hazard is a condition that increases the likelihood or severity of a loss. There are three types:
| Hazard | Definition | Example |
|---|---|---|
| Physical | A tangible bodily or environmental condition | High blood pressure, a dangerous occupation |
| Moral | Dishonesty or a tendency toward loss for gain | Faking facts to collect; intent to defraud |
| Morale | Carelessness or indifference because insurance exists | Reckless behavior since "insurance will pay" |
A memory hook: moral = dishonesty (intent), while morale = carelessness (attitude).
Law of Large Numbers
The law of large numbers states that the larger the number of similar exposure units, the more accurately the insurer can predict the proportion of losses for the group as a whole. Insurers cannot predict whether you will die this year, but with millions of insureds they can predict total deaths closely enough to price premiums. This is why a broad, homogeneous pool is essential.
Adverse Selection
Adverse selection is the tendency of higher-than-average risks to seek or keep insurance more aggressively than standard risks. A person who knows they are seriously ill is more motivated to buy a large life policy. Insurers counter adverse selection through underwriting, medical exams, and substandard (rated) premiums so the priced risk matches the actual risk.
Insurable Interest
Insurable interest means the policyowner must face a genuine financial loss from the insured's death. A person always has insurable interest in their own life, and may have it in a spouse, a dependent, a business partner, or a key employee.
Critical exam rule: For life insurance, insurable interest must exist only at the time of application, not at the time of death. (This contrasts with property insurance, where it must exist at the time of loss.) So a divorced ex-spouse who legitimately owned a policy before the divorce can still collect.
Indemnity vs. Valued Contracts
- An indemnity contract restores the insured to their pre-loss financial condition, paying no more than the actual loss (most property/health insurance).
- A valued contract pays a stated, agreed amount regardless of actual loss. Life insurance is a valued contract because a human life cannot be measured in exact dollars; the policy pays the agreed face amount.
Risk Management Methods (STARR)
Five ways to handle risk, remembered as STARR:
| Method | Meaning | Example |
|---|---|---|
| Share | Spread risk across a group | Pooling, reinsurance |
| Transfer | Shift risk to another party | Buying insurance |
| Avoid | Eliminate the exposure entirely | Never take up skydiving |
| Retain | Keep the risk yourself | A deductible, self-insurance |
| Reduce | Lower frequency or severity | Wearing a seatbelt |
Insurance is fundamentally the transfer method.
Elements of an Insurable Risk
For an insurer to accept a risk, it should generally meet these conditions:
- The loss must be due to chance (accidental, outside the insured's control).
- The loss must be definite and measurable in time, place, and amount.
- The loss must be predictable in the aggregate (law of large numbers).
- The loss must not be catastrophic to the insurer (avoid concentrated exposure).
- A large enough pool of homogeneous units must exist.
- The premium must be economically feasible relative to the potential loss.
Putting the Concepts Together
These fundamentals are not abstract trivia; they explain why life insurance is structured the way it is.
- Because death is a pure risk that is definite (it will happen) but uncertain in timing, the insurer uses mortality tables and the law of large numbers to price coverage.
- Because the company cannot let unhealthy applicants self-select into large policies (adverse selection), it underwrites each applicant and assigns a risk class (preferred, standard, or substandard).
- Because a life cannot be measured in exact dollars, the policy is a valued contract paying a stated face amount, and the law requires insurable interest at application to keep the arrangement from becoming a wager.
Expect the exam to test these relationships, not just the definitions in isolation, for example by asking which method of risk management insurance itself represents (transfer) or why a stranger cannot insure a celebrity's life (no insurable interest, illegal wagering).
Worked example: A healthy 30-year-old and a 30-year-old with terminal cancer both apply for a $500,000 policy. The insurer cannot predict which individual will die, but mortality tables let it predict roughly how many out of 100,000 similar 30-year-olds will die this year. Underwriting then separates the two applicants: the healthy one is issued at standard rates, while the terminally ill applicant is rated or declined, blocking the adverse selection that would otherwise drain the pool.
An applicant takes out a life policy on a business partner, then the partnership dissolves years later. At the partner's death, the original applicant still owns the policy. Why can the death benefit be paid?
A person drives recklessly, reasoning that 'my insurance will cover any accident.' This careless attitude is best classified as which type of hazard?