Insurance is the ultimate risk management instrument. Risk is a part of our lives because of uncertainty and the lack of control that we have over events. Not all dangers or uncertainties are insurable and not all insurable ones are worth covering. Those that are insurable must meet specific criteria. The idea behind this is to discourage illegal activity, antiselection and speculation.
Risk can also be classified as speculative versus pure and fundamental versus particular. A speculative one is the definition of a gamble. It may result in a loss, a gain or neither. Pure ones differ in that they result in a loss if they occur, but no loss if they do not. Insurance therefore covers pure risks, since there is no element of gain with it. This is enshrined in the principle of indemnity. In non-indemnifying insurance contracts (life insurance for e.g.), financial underwriting helps enforce the indemnifying role of insurance.
A fundamental risk is one that would affect society as a whole or a massive group of people. A particular risk is limited to individuals or a restricted group of people. Insurers generally cover particular risks. They guard against fundamental angers or uncertainties through the principle of proximate cause. Covering fundamental runcertainties would raise premiums too significantly for insurance to be affordable.
To ensure that premiums are affordable and that insurance is for noble reasons, risks covered must be classified as insurable. The criteria that must be satisfied for a pure risk to be considered insurable include:
1) The existence of insurable interest
2 The loss arising from the risk must be reasonably unexpected and accidental (not caused by the insured or policy owner.
3) The loss must be measurable, limited to pure financial value and not based on sentimental value.
4) Losses must not be catastrophic.
5) There must be a pool of similar risks. Without this, premiums would be too high.
6) The insurance affected must be in accordance with public policy.
Once these elements are satisfied, a pure risk can be considered an insurable risk. This principle is not only for insurers to follow, but for the insured as well. Good risk management strategy does not suggest that you insure all insurable risks. This would be unnecessary. Only a risk that would cause a severe loss that would take you months or years to recover should be considered insurable. For e.g. saving individual coverage for dental appointments may be unnecessary unless the expenses are critical and ongoing. Understanding risk would give you a better idea of the role of insurance in your financial plan.
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