What is Risk in Insurance? A comprehensive note

In this article we made a comprehensive and detailed study on the Concept of Risk in Insurance including its meaning, categories, characteristics, principles and elements

 

1. INTRODUCTION

 

Insurance is an essential component of modern life, providing individuals and businesses with financial protection against unforeseen events and potential losses. While insurance policies offer a safety net, it is crucial to understand the concept of risk in the context of insurance law.

 

2. MEANING OF RISK

 

We all anticipate countless risks in our daily life. In life and business there lies a plenty of risk. Risk is closely connected with loss. Every risk result in loss of one or other kind. There can be loss due to perils of sea, illness, death, fire, earthquakes and so on. The risk cannot be eliminated but loss can be. The function of insurance is to protect the insured from variety of risks he anticipates by spreading the loss to persons who agreed to co-operate each other at the time of loss by making contributions to the common fund. When anybody of them is exposed to risk, such loss is made good out of the common fund. In other words, risk of financial loss to a person is assumed by another. Insurance cannot arrest risk from taking place but guarantees the payment of loss and thus protects the insured from sufferings. The type of risk is the base for ascertaining the premium rate.

 

3. RISK CATEGORIES IN INSURANCE

 

Insurance companies categorize risk into two main types: pure risk and speculative risk.

1. Pure Risk: Pure risk involves situations where there is only a possibility of loss or no loss at all. Examples include natural disasters, accidents, and illnesses. Insurance companies primarily deal with pure risks as they align with the fundamental purpose of insurance, which is to provide financial protection against unforeseen events.
2. Speculative Risk: Speculative risk involves situations where there is a possibility of gain, loss, or no change. Examples include investing in the stock market or starting a new business venture. Insurance does not typically cover speculative risks because they involve a chance of profit, and insurers are designed to handle situations where the outcome is purely detrimental.

 

4. CHARACTERISTICS OF RISK

 

Risk which can be insured by insurance companies typically share seven common characteristics:

 

1. Large number of similar exposure units

 

Since insurance operates through pooling resources, the majority of insurance policies are provided for individual members of large classes, allowing insurers to benefit from the law of large numbers in which predicted losses are similar to the actual losses.

 

2. Definite loss

 

The loss takes place at a known time, in a known place, and from a known cause. The classic example is death of an insured person on a life insurance policy. Fire, automobile accidents, and worker injuries may all easily meet this criterion. Other types of losses may only be definite in theory. Occupational disease, for instance, may involve prolonged exposure to injurious conditions where no specific time, place or cause is identifiable.

 

3. Accidental loss

 

The event that constitutes the trigger of a claim should be fortuitous, or at least outside the control of the beneficiary of the insurance. The loss should be pure, in the sense that it results from an event for which there is only the opportunity for cost. Events that contain speculative elements, such as ordinary business risks or even purchasing a lottery ticket, are generally not considered insurable.

 

4. Large loss

 

The size of the loss must be meaningful from the perspective of the insured. Insurance premiums need to cover both the expected cost of losses, plus the cost of issuing and administering the policy, adjusting losses, and supplying the capital needed to reasonably assure that the insurer will be able to pay claims. For small losses these latter costs may be several times the size of the expected cost of losses. There is hardly any point in paying such costs unless the protection offered has real value to a buyer.

 

5. Affordable premium

 

If the likelihood of an insured event is so high, or the cost of the event so large, that the resulting premium is large relative to the amount of protection offered, it is not likely that the insurance will be purchased, even on offer. Further, as the accounting profession formally recognizes in financial accounting standards, the premium cannot be so large that there is not a reasonable chance of a significant loss to the insurer. If there is no such chance of loss, the transaction may have the form of insurance, but not the substance.

 

6. Calculable loss

 

There are two elements that must be at least estimable, if not formally calculable: the probability of loss, and the attendant cost. Probability of loss is generally an empirical exercise, while cost has more to do with the ability of a reasonable person in possession of a copy of the insurance policy and a proof of loss associated with a claim presented under that policy to make a reasonably definite and objective evaluation of the amount of the loss recoverable as a result of the claim.

 

7. Limited risk of catastrophically large losses

 

Insurable losses are ideally independent and non-catastrophic, meaning that the losses do not happen all at once and individual losses are not severe enough to bankrupt the insurer; insurers may prefer to limit their exposure to a loss from a single event to some small portion of their capital base. Capital constrains insurers' ability to sell earthquake insurance as well as wind insurance in hurricane zones. In the U.S., flood risk is insured by the federal government. In commercial fire insurance it is possible to find

 

5. IMPORTANT PRINCIPLES

 

1. Principle of Causa Proxima

 

The doctrine of proximate cause is expressed in the maxim Causa Proxima non remota spectator, which means that the proximate and not the remote cause shall be taken as the cause of loss. It is another important principle of insurance. It lies down that the proximate cause (nearest cause) is to be the basis of determining the liability of the insurer and not the remote cause. If the immediate risk is insured, the insured will be indemnified. It means that if the risk or cause of loss is not specifically covered under the policy, no compensation will be paid.

 

It is, therefore, necessary to identify the risk to determine whether it is payable under the policy or not. When the loss is caused by more than one cause and if one of the causes is uninsured one, the insurer shall be liable to the extent of the effects of insured risk, if it can be separated or ascertained. The insurer will not be liable if the effects of the insured risk cannot be separated from uninsured one. The principle of causa proxima is not applicable to life insurance.

 

2. Principle of Contribution

 

The principle of contribution comes in to play, where there are two or more insurance on one risk. The aim of the contribution is to call upon the different insurers to distribute the actual amount of loss who are liable for the same risk under different policies in respect of the same subject-matter. This type of specific risk insured under more than one policy is also called as “double insurance”. It is applicable in all types of insurance whether it is contingency, life or indemnity insurance. But one can insure himself for any number of risks with any number of insurers or under different policies with the same insurer. The price varies from insurer to insurer, as with any product or service. Different types of insurance cover require different premiums based on the degree of risks. The whole of the claim under all such policies can be recovered.

 

6. ELEMENTS OF RISK

 

Various factors affect the calculation of premium against an event insured. The physical events can be estimated scientifically as in life insurance but some events cannot be ascertained accurately such as exact dates of occurrence of fire, accidents, floods etc. The risk can be evaluated by various methods. If more loss is expected, higher premium may be charged. Theory of Probability is used to evaluate the risk or we can say that the probability of loss is calculated before or at the time of insurance. Generally, the premium is calculated by considering the following elements:

 

a. In Life insurance, the factors which may affect the calculation of risk premium are:

 

i. Age

 

It is the most important factor which may affect the risk. Initially, the minimum and maximum age limits were fixed to avoid adverse selection. But in modern times the age barrier is crossed conditionally and the premium is based on age of the life to be assured.

 

ii. Physical Condition

 

An insurer is very particular about the physical condition of the applicants such as height, weight (over and underweight), eye-sight, hearing, heart, lungs, nervous system etc. The insurer provides a form to the applicant to extract information on the physical status of the applicant. Such information is further corroborated with a medical examination.

 

iii. Personal History and Present Habits

 

The history of a person helps in revealing the possibility of mortality. The past health records (medical examinations, injuries and illness), past habits (drugs or alcohol) previous refusal by any insurer on these grounds etc. are very cautiously examined.

 

iv. Family History

 

The family history is also examined carefully as it is significant to know the transmission of certain characteristics through heredity. A person's height, weight, heart, lungs etc. more or less follow family characteristics. So, the information regarding health and habits of other family members, in particular, parents, brothers and sisters are asked for by the insurers.

 

v. Occupation

 

It is also one of the most important factors which may affect the risk. The occupation of a person is also significant to affect the decision of the insurer and the rate of premium. The persons working in hazardous establishments such as flying or gliding, chemical, match-box, liquor industries etc. are more prone to diseases and accidents at all the times. The chemical effect, dusty conditions, excessive mental and nervous strain, less or uncertain income stress may affect the health of an applicant.

 

vi. Place of Residence

 

The dusty or unventilated house, unhealthy unsanitary or environment, geographical location, climate, condition of dwelling place may affect the risk.

 

vii. Race and Nationality

 

The rate of mortality differs from race to race and nation to nation. The climate and lifestyle of a country affects the health of its countrymen. Similarly, certain geographical factors affect some countries such as countries near to equator have higher mortality rate. In India, it is observed that persons belonging to higher strata of the society live longer than the persons belonging to Scheduled Castes and Scheduled Tribes.

 

b. In Property or Fire insurance, the factors which may affect the risk are:

 

i. Construction of Property

 

The nature of construction of a building is an important factor in calculating premium amount. A building made of wood is more prone to risk than that of a building made of bricks and cement. The fire-proof building is sounder than that of a building without fire-proof characteristics. Other factors which are importantly considered while calculating risk are height, area, number of plots, quality of roof and walls etc. of a building The height may add difficulty while fighting a fire and as the larger number of plots requires lift, it may cause chances of ignition of fire accidents.

 

ii. Usage of Property

 

Another important factor which affects the risk considerably is the usage of the building proposed to be insured. There is direct relationship between the building and its contents. A building used for dwelling purpose is always at a better risk than a showroom. A building used for keeping or preparing combustible goods such as fire crackers, match-box is more dangerous than that of a general store. This factor apparently compels insurance companies to change their premium rates from building to building. Other important factors are nature of raw material, place of storing them, process of manufacturing etc. which influences the premium rates.

 

iii. Location of Property

 

It is also another factor while considering the insurance of a property. A building situated in a congested locality involves higher degree of exposure to risk. It may add difficulty in fighting a fire also. If it is situated in a thickly-wired location, fire may be caused due to naked wires, short-circuits or faulty installation of wires. Similarly, if the building is adjoined with hazardous nature of activities or distance from a fire-brigade station or water supply is much far, it may influence the degree of risk.

 

iv. Preventive Measures

 

In case of fire, if the protection facilities are available, the fire may be extinguished in its initial stage. The premium is charged less from buildings which fulfils the fire safety norms than those where such safety measures is not followed. We can say that by implementing safety norms and implanting fire extinguishing apparatus or storing water at work place one can reduce the degree of risk which may result in lesser premium.

 

c. In Marine insurance, the factors which may affect the risk are:

 

i. Management of Cargo Vessel

 

The cargo vessels which are efficiently managed by its management such as taking due care in its upkeeping, appointing efficient officers and crew are required to pay lesser premium than that of managements which are negligent, indifferent towards cargo care or who do not appoint efficient officers and crew members on board. It is quite obvious that insurers do not treat them alike.

 

ii. Quality of the Vessel

 

The fitness of the vessels carrying cargo is also taken into account while insuring the risk. It is not so always that the premium is charged lesser for the new ones but it may depend upon its frequency of exposure to the sea. For example, if a new ship has a very slow speed than the ships manufactured of same category, the insurer may charge the higher premium from it as the ship will take more time than others to cover the same journey and is exposed to risk manifold times by remaining in the sea for longer period than others.

 

iii. Construction, Class and Nationality of the Vessel

 

Insurers take into the account the quality of the vessels in calculation of the premium. It is very important to know the detailed descriptions of the vessel such as its owner, goodwill, structural plan, materials used in its construction, structural strength, adaptability to carry various items, age and physical condition to bear stresses and strains. In some countries, ships are categorized in classes based upon the above said factors.

 

6. CONCLUSION

 

Risk is an integral part of insurance law, shaping how policies are structured, premiums set, and claims handled. Understanding the nature of risk and the importance of risk mitigation is vital for both insurance companies and policyholders. Adhering to the principle of utmost good faith, fulfilling the duty of disclosure, and taking proactive steps to mitigate risks will lead to a healthier insurance relationship and a more secure financial future for all parties involved.