Risk, Hazards, Perils & How Insurance Works

What Risk Is, and Which Kind Is Insurable

Risk is uncertainty about a future outcome - specifically, the chance that a loss will occur. The exam draws a hard line between two kinds of risk, and only one is insurable.

Pure risk is a situation with only two possible outcomes: a loss or no loss. There is no opportunity for gain. A house may burn down (loss) or stand untouched (no loss), but owning it cannot make you money by chance. Pure risk is the only kind of risk insurance covers.

Speculative risk carries three outcomes: loss, no loss, or gain. Gambling at a casino, buying stock, and opening a business are speculative because you can profit. Because a gain is possible, speculative risk is not insurable - a frequent exam distractor offers "investing in the stock market" as something insurance covers. It does not.

The Four Methods of Handling Risk

Every exam tests the four ways a person or business can deal with pure risk. Memorize them as avoid, retain, reduce, transfer - sometimes given as the acronym STARR (Sharing, Transfer, Avoidance, Retention, Reduction), but the core four are the testable set.

Insurance is the transfer method. The insured pays a relatively small, certain premium to transfer an uncertain, potentially large loss to the insurer. Note the overlap the exam loves: a deductible is a form of retention because the insured keeps (retains) the first dollars of any loss. Sharing (splitting risk among a group, as a partnership or pool does) is sometimes listed as a fifth method.

Perils vs. Hazards (Do Not Confuse Them)

These two terms appear on nearly every P&C exam and are easy to mix up.

A peril is the actual cause of a loss - fire, lightning, windstorm, hail, theft, collision, vandalism, smoke, or explosion. When a policy is a "named-peril" form, it lists the specific perils it covers.

A hazard is a condition or situation that increases the chance that a loss will happen, or makes it worse. Hazards do not cause the loss themselves; they make the peril more likely. There are three classic types:

• Physical hazard - a tangible condition of property, person, or surroundings. Examples: oily rags in a basement, an icy sidewalk, a frayed electrical wire, slick roads. It is something you can see or touch.
• Moral hazard - a dishonest tendency that increases loss, such as a person who would intentionally cause a loss or pad a claim to collect insurance money. A history of arson or insurance fraud is the classic example.
• Morale hazard - an attitude of carelessness or indifference to loss because insurance exists. The insured leaves the keys in the car or fails to lock the door, reasoning "the insurance will cover it." Morale = a careless mood; moral = dishonesty.

Exam tip: A clogged sprinkler is a physical hazard; an arsonist's intent is a moral hazard; leaving a candle burning because "I'm insured" is a morale hazard. The peril that actually burns the building down is fire.

How Pooling and the Law of Large Numbers Make Insurance Work

Insurance works by pooling - combining the small premium contributions of many policyholders into a fund from which the relatively few who suffer losses are paid. This is the spread of risk: one person's catastrophic loss is shared across the whole pool, so no single insured is financially destroyed.

The engine behind pooling is the law of large numbers. This mathematical principle says that the larger the number of similar, independent exposure units observed, the more closely the actual results will match the predicted (expected) results. An insurer cannot predict whether your house will burn this year, but it can predict with great accuracy how many of 1,000,000 similar houses will burn. That predictability lets actuaries set a premium that covers expected losses plus expenses and profit.

For a risk to be insurable, it should meet several elements of an insurable risk:

1. The loss must be due to chance (accidental, not intentional).
2. The loss must be definite and measurable - clear in time, place, cause, and amount.
3. The loss must be predictable for the group so premiums can be calculated.
4. The loss must not be catastrophic to the insurer (which is why floods and war are often excluded and handled separately).
5. There must be a large number of similar exposure units.
6. The premium must be economically feasible - affordable relative to the coverage.

Adverse Selection and Reinsurance

Adverse selection is the tendency of people with a higher-than-average chance of loss to seek insurance more eagerly than average or low-risk people. A person in poor health wants life insurance most; a driver with many accidents most wants auto coverage. If insurers accepted everyone at the same price, the pool would fill with bad risks and premiums would not cover losses.

Insurers control adverse selection through underwriting - the process of selecting, classifying, and pricing applicants so that each pays a premium appropriate to the risk they bring. Underwriting keeps the pool balanced and the rates fair.

To protect themselves against losses too large for their own pool, insurers buy reinsurance - insurance for insurance companies. The original insurer (the ceding company) transfers part of its risk to a reinsurer. The portion the ceding company keeps is its retention; the amount passed on is ceded. Reinsurance lets a single insurer write a large policy (or cover a hurricane-exposed coast) without risking insolvency, spreading catastrophic risk across the global market. This is why a Texas insurer can write windstorm-exposed property and still survive a major Gulf hurricane.