Regardless of the type of insurance under discussion, the concept of risk and loss is a factor.
Risk and Loss Management
Risk is a part of everyday life. Risk refers to the possibility of losing something. Risk Management is process of dealing with risk in order to minimize the impact of a loss when it occurs. The factors involved in risk management are risk, loss, exposure, perils, and hazards.
Risk
Risk refers to the chance of a loss occurring. The two types of risk are pure risk and speculative risk. Where pure risk is involved, there is no chance of a gain. The only two possibilities are that nothing happens, or a loss occurs. Examples of pure risk are the risk of unanticipated death, illness, or disability.
Speculative risk, on the other hand, comes with the possibility of a gain as well as a loss. For example, an individual may speculate on the stock market. In this scenario, it is possible for the invested funds to increase in value. Of course, it is also possible for them to decrease in value. So speculative risk includes a possibility of gain in addition to a possibility of loss. Speculative risk is not insurable. Some pure risk is insurable, though not all.
Loss
In insurance terms, a loss is an unplanned decrease in value. Losses that are insurable are either direct losses or indirect losses. Losses that are the immediate result of events covered under an insured peril are called direct losses. Indirect losses are less common but may still be considered an insured loss.
One example of a direct loss is the death of a provider in a family. The death results in a decrease in household income. The decrease in income is an indirect loss and the death itself is a direct loss.
Exposure and Exposure Units
The condition of being subject to a possible loss is called exposure. Insurers base premiums directly on the degree of exposure they face. Certain occupations, for example, are known to be far more dangerous than others, and hence carry a much higher degree of loss exposure. Consequently, insurers will charge higher rates of premium to cover policy holders in these more dangerous occupations.
Exposure units are the values given to risks and represent the basis for the premium charged. For example, more dangerous occupations will necessitate the need for more exposure units, ultimately resulting in a higher premium.
Peril and Hazard
A peril is not the same as a hazard, though the two terms are often used interchangeably. A peril is whatever the insurance is protection against. Examples include death, dismemberment, disability, etc. The peril is the direct cause of a loss.
A hazard, on the other hand, is the condition that increases the odds of a peril or otherwise increases the potential severity of a loss. Insufficient lighting, for example, can result in a more dangerous environment than might otherwise exist if lighting was adequate. In this case, the insufficient lighting is considered a hazard. If a crime occurs because of the poor lighting, the crime is the peril. Any negative consequences of the crime (theft, injury, death) is the loss. Other examples of hazards are exposed electrical wiring in a dwelling, potholes in a road, cigarette smoking, alchohol or drug abuse, and poor diet. All of these increase the likelihood of injury, sickness, or death.
Potential Hazards in Life and Health Insurance
The three basic types of hazards involved in life or health insurance are moral hazards, morale hazards, and physical hazards. Moral hazards are actions or characteristics of a particular individual that make the chance of a loss greater. Examples might be a chemical dependency such as drugs, alcohol, or nicotine. Another example of a moral hazard would be a tendency toward fraud.
A Morale Hazard, unlike a a moral hazard, originates as a state of mind, attitude, or indifference. An example of a morale hazard would be a tendency to drive recklessly. As a matter of fact, any reckless behavior that occurs because the insured knows that he or she has insurance to cover losses is considered a morale hazard.
Physical Hazards are physical, rather than psychological, traits that increase the possibility of a loss. They are the result of a physical condition rather than a defective character. One example of a physical hazard would be high cholesterol. To protect the insurer from losses due to physical hazards, they often require applicants for insurance to undergo medical exams.
Risk and Loss Management Techniques
The best methods of dealing with risk usually depend on the type of risk. The process of dealing with the risks that we encounter on a daily basis is called Risk Management. Some typical risk management practices are avoiding the risk entirely, reducing the risk, retaining the risk, and sharing the risk, and transferring the risk. Each of these is discussed below.
Risk and Loss Avoidance
The first common way to manage risk is to simply avoid it altogether. Of course, it isn’t possible to avoid all risk, but many of the most dangerous risks in life can easily be avoided. For example, refusing to participate in a dangerous sport such as base jumping is a way to avoid injury or death.
Risk and Loss Reduction
Even though it often impossible to completely eliminate the possibility of risk, it is often possible to reduce the possibility. Regular exercise, a healthy diet, and abstention from unhealthy habits such as smoking can reduce the risk of many diseases significantly.
Even the most health-aware individual can become sick, and sometimes such individuals contract diseases normally associated with poor health habits, such as lung cancer or heart disease, and everyone dies, regardless of his or her attention to health. The complete elimination of the risk of loss is simply not possible.
Risk and Loss Retention
Risk retention means accepting the reality of risk and planning for losses by setting aside enough personal resources to account for such losses. Risk retention may be the most effective means of dealing with risk, as long as the possibility of a loss is relatively low, or the value of the potential loss itself is small. In cases where the potential financial loss is significant or the probability of such a loss is high, risk retention may end in economic disaster.
One example of risk retention is the deductible. The deductible is the portion of loss that the policy holder will pay out of pocket before the insurance coverage takes over. For example, a $1000 deductible on an auto insurance policy means that the insurance company is responsible for just $9000 of a $10000 loss. The owner of the automobile would pay the $1000 out of pocket. The use of deductibles discourage policyholders from making frivilous or minor claims for every nick or ding in the automobile. The owner is agreeing to retain a portion of the risk in order to pay lower premiums.
Risk Sharing
Risk sharing was one of the first forms of insurance. In earlier history, people joined together and agreed to help one another in times of crisis or loss. It worked well for relatively small groups, but becomes more cumbersome as the group size grows.
Risk Transfer
Most insurance today is a form of Risk Transfer. In risk transfer, losses are actually transferred to a third party, such as an insurance company. In exchange for transferring this risk, the individual or business pays the insurance company a premium. The insurance company agrees to pay for losses that occur in exchange for much smaller payments over time.
Elements of insurable Risk
Insurance companies will not insure against all risks. Risks that can be insured against are called “insurable” risks. An insurable risk must meet certain requirements before an insurance company will cover the risk:
– The location, time, and cause of the loss must be definable.
– The amount of the loss that is to be insured must be measurable.
– The insured event must be beyond the control of the insured (i.e., accidental).
– The risk must be part of a large group of similar [or homogeneous] risks so that the insurance company can predict the probability of a future loss.
– The risk must not be catastrophic in nature. Insurers do not cover acts of war or other perils that might originate from disputes between nations.
– The risk must not be expressly excluded by the policy or company.
Underwriting
When an insuring company receives an application for insurance coverage, a process known as underwriting is initiated. Through this process, insurance company representatives known as underwriters determine if the company should accept or reject the proposed risk. That is, the underwriters seek to determine if the applicant is an insurable risk. Underwriters use a variety of data, including the application and the agent’s report, to determine if an applicant is insurable.
Law of Large Numbers
Insurance is largely based on statistics such as averages, probabilities and odds. It relies largely on the principle of the law of large numbers, a statistically accurate way to predict future losses. Based on the idea that predictions become more accurate as the number of exposures increase, the law of large numbers is the mathematical principle of probability that insurance is based on.
Using the law of large numbers and risk data, insurance company mathematicians, called actuaries, determine the likelihood of death (mortality) or serious illness (morbidity) for males and females at any given age. The mortality and morbidity tables they create are then used by insurance company underwriters to determine premium rates for each policy applicant. Mortality tables are used in determining life insurance premiums, while morbidity tables are the basis of health insurance premiums.
Adverse Selection
One important objective of the underwriting process is to avoid what is know as adverse selection by applicants. Adverse selection refers to the tendency of applicants who are at greater risk of loss to apply for insurance. Insurance companies depend on population pools in order to remain financially solvent. In other words, they gain a greater return from policy holders who never need insurance, and are thus able to pay claims for those who do. For example, those who have a serious disease are more likely to try to get health insurance than someone who is relatively healthy.
Insurance Regulation
States are the primary regulators of insurance. The respective insurance agencies in each state are responsible for regulating insurance companies that do business in the state, in addition to regulating the producers who are licensed in the state and all insurance transactions that take place in the state. The insurance commissioner (or director, as he or she is known in some states) is the highest ranking insurance regulating official in each state.
The federal government also regulates the insurance industry, though to a generally lesser degree than the states. Some of the insurance-related laws issued at the Federal level are:
~ the Fair Credit Reporting Act (FCRA)
~ the Employee Retirement Income Security Act (ERISA)
~ the Consolidated Budget Reconciliation Act (COBRA)
~ the Health Insurance Portability and Accountability Act (HIPAA)
~ the Patient Protection and Affordable Care Act (PPACA)
Regulatory Associations
To avoid chaos in regulations due to the fact that each state is largely responsible for their own insurance industry, there are several nationwide associates which help to coordinate regulations between states. Among these are::
- The National Association of Insurance Commissioners (NAIC). This association represents the insurance departments of every state, the District of Columbia, and several U.S. territories. The association members meet periodically to discuss and review insurance-related issues and to promote regulations that are uniform throughout the states. Though their suggestions are not binding, most states adopt them in some form.
- The National Conference of Insurance Legislators (NCOIL). This association consists of lawmakers from each state. The NCOIL assists state lawmakers in setting regulations that best serve their constituents. NCOIL works with the NAIC to help lawmakers understand the importance of NAIC insurance regulations.
It should be noted that variable annuities and life insurance are primarily regulated by the Financial Industry Regulatory Authority (FINRA). FINRA is a private entity that functions as a self-regulatory organization (SRO) which oversees financial transactions by securities brokerage firms such as those which sell variable insurance products and exchange markets.
Risk and Loss Key Points
- Risk refers to the “chance of loss.”
- Speculative risk (such as in the stock market) is not insurable. Only pure risk is insurable.
- A loss is an unexpected decrease in financial value.
- A peril is what the insurance protects against.
- A hazard is anything that increases the chance of a peril or the severity of a loss, should one occur.
- Deductibles are used in insurance to ensure that the insured is responsible for some risk.
- Risk transfer, or transferring the loss to a third party, is what most forms of insurance is based on today.
- Underwriting is a process in which the insurance company decides whether the risk in an application should be accepted or rejected.
- Insurance is based on the mathematical principle of probability called the law of large numbers.
- Mortality tables are used to determine life insurance premiums, while health insurance premiums are based on morbidity tables.
