Wrecks & Fires

Chapter 2

Perils & Risk

Defining Risk

  Insurance, as every agent should know, is bought to offset the risk which exposes a person or persons to losses resulting from perils.  The term “risk” is often interchanged with the terms “hazard” or “loss.”  Risk is generally considered to be the uncertain potential for loss.  There are varying degrees of risk; risk is usually not desired.

  Agents talk all the time about risk, but most of us really don’t pay any real attention to it.  If we did we wouldn’t say some of the stupid things we do to clients.  Everyone is exposed to risk every day of their lives.  Agents expose themselves to risk by promising things that can’t be delivered or by failing to say what a policy won’t pay for.  Any type of policy is designed to offset some type of risk.  Even an annuity, which is often considered an investment, is actually a policy to offset risk: the risk of living too long without enough money.

Any type of policy is designed to offset some type of risk.

In simplistic terms, insurance is the transfer of risk from one entity to another.  An insurance policy transfers the threat of financial loss from the policyholder to the insurance company.  Of course, if insurance were merely risk transfer, then insurance regulation would simply address this issue.  As we know, insurance deals with more than just risk.  Although risk is always involved in the mathematics, insurance deals with loss, profit, and even investments.

Insurable Exposures

  It has been said that an insurable exposure is one for which insurance may be purchased.  That determination is the function of the analysts and the underwriters employed by insurance companies.  Agents should remember this definition because it really is a concise statement of insurance as well as exposures.  The keys words here are “insurable exposure” with the emphasis on “insurable.”  Many exposures exist that have no insurance products to cover them.  When this is the case, the exposure is probably one which would not create a profit for the insurance company.  Therefore, they have no desire to create an insurance product to cover it.

  The next question is obvious: “Why can’t insurance be bought to cover all risks?”  In theory, it could be.  The reason all risks are not covered, however, is because insurance companies want to stay in business.  Even the ones that offer coverage at cost want to remain a viable entity (they want to stay in business).  So, the next question is: “Why would covering all exposures put a company at risk?”  The answer to this question becomes more complicated.

  People might think they would like to be insured for everything, but in practice they don’t follow that thinking through with their money.  For example, when an agent comes into a home, one of the first questions asked by the consumer is “What’s it cost?”  Consumers must be able to afford the insurance they buy.  Even insurance companies want consumers to be able to afford the premiums.  There are costs involved in underwriting a policy.  If the consumer only pays one or two monthly premiums and then drops the policy, there is no profit margin.

  There is another reason all exposures to risk do not have a policy available to offset them.  For a type of insurance to continue there must be enough consumers willing to pay the cost of the premium.  If the premium is too high, the insurer will not have a large enough client base to make the policy profitable.  If the policy is not profitable, the company will not continue to offer it.  A well-known example of this is dental insurance for individuals.  Unless a person is lucky enough to be on a group plan, individual dental insurance is very hard to find.  When it is available, the premiums often make the consumer hesitate to purchase it.  Dental plans have maximum benefit amounts to protect themselves from excessive losses.  Even so, dental plans are often types of coverage that companies lose money on.  The only people who purchase dental plans are those who expect to use them.  These consumers expect to go routinely for cleaning, and other dental work. Therefore, companies know that dental plans will have claims.

  Some types of risk would not be sensible to insure.  In fact, every aspect of our lives involves some type of risk, so it would be unlikely that every possibility could be anticipated.  Even Charlie Brown faced risk every day.  Every time he prepared to kick the football, he faced the risk that Lucy would pull it away at the last minute.  We laughed as he landed on his back in failure time and time again.  If these were real characters, at some point Charlie would be suing Lucy for intentional injury and possibly even harassment.  With her personality traits, Lucy would be wise to carry some sort of liability coverage.

Law of Large Numbers

  The ability to predict probabilities, a necessary part of predicting risk and loss, requires the use of the "law of large numbers."  Insurance companies do not want to insure a risk that will affect thousands of people at once, although that can still happen.  For example, hurricane Andrew affected thousands of people over a span of only a few hours.  The point of underwriting is to minimize monumental losses or bring in enough premium to make such losses worthwhile.

Chance of Loss

  The words, "chance of loss," are often used in place of the word or term "risk."  However, they may not always mean exactly the same thing.  "Chance of loss is the long-run relative frequency of a loss" states the textbook Principles of Insurance written by Robert Mehr and Emerson Cammack.  The chance of loss is often stated as a percentage since it often expresses mathematical probabilities of probable numbers and severity of losses out of a given number of exposures.  To put this in simpler terms, if a person flips a coin, there is the 50/50 chance that heads will land face-up.  This may be stated as 50/50, 1/2 or 50%.  So it is with chance of loss.  The probable number of losses is the numerator (top number) and the number of exposures is the denominator (bottom number).  When flipping the coin, the individual has a one out of two (1/2) chance of turning up heads.  This equates into a 50% chance of getting heads up or a 50/50 chance.

  When insurance companies figure their chances of loss, it is a serious venture.  To miscalculate such chances could cause the company serious financial losses.  This is true regardless of the type of policy involved.  As a field agent, I have heard all of the jokes about the company actuaries being humorless, statistical people.  Agents probably invent these jokes because they don’t always like the decisions made by actuaries.  However, I have found these individuals to be as varied as any other group in their personalities, but they do have to be very serious about their business.  Otherwise, the companies they work for wouldn’t stay profitable.

Chance of loss is also the basis upon which rates or premiums are established by  the insurance companies.  A degree of accuracy is absolutely necessary. 

Morale and Moral Hazards

  Insurance protection brings about another factor: morale and moral hazards.  While similar, each type of hazard is actually distinct.  A morale hazard (with an ‘e’) involves human carelessness or irresponsibility, rather than an intentional act.  This might occur because an individual or a business was aware that they had insurance protection, so their actions were not well thought out.  Moral hazard (no ‘e’ at the end), on the other hand, does involve an intentional human act.  Moral hazards include such things as arson for profit and other types of fraud.  Both types of hazards include humans and their actions.  The difference lies in the intent of those human actions.

The difference between Morale and Moral Hazards has to do with intent: one type involves carelessness while the other involves intentional acts.

  Insurance, as we know, is purchased to offset the risks we are exposed to, whether that risk involves our homes, cars, health or lives.  Insurance is intended to bring what we call “peace of mind.”  Agents tend to overuse this phrase, but it is accurate.  Most of our clients do not want to experience an automobile accident, yet they carry insurance to cover it.  Few of us would want our house to burn down, yet we carry insurance to cover it just in case it happens.  The insurance policy brings the comfort of knowing we would be protected financially if these large losses happen.  Therefore, we have peace of mind.

  Insurance underwriters and analysts rely on specific risk numbers to offset their chance of loss.  To use a gambling term, one might say that insurance companies "play the numbers."  It has been said that insurance companies are the best scorekeepers there are.  They are more likely to know the possibilities of either loss or gain than anyone else.

  The "law of large numbers" is related to the degree of risk.  Of course, insurance agents and insurance agencies also play the “numbers” game.  Most professionals are well aware of how many times they must hear “no” before the “yes” comes along.  Without becoming involved in the complicated mathematics of it, the law of large numbers basically states: “the greater the number of similar units exposed to a similar loss, the more accurate the loss predictions based on that data will be.”  The law of large numbers may also be called the law of probability.  Of course, the law of large numbers is not really an actual law at all.  It is an entire branch of mathematics.

The law of large numbers may also be called the law of probability.

  As early as the 17th century, European mathematicians were putting together crude mortality tables.  They discovered that the percentage of female and male deaths among each year's births tended toward a constant if sufficient numbers of births were tabulated.  It was not until the 19th century that Simeon Denis Poisson named this principle the "law of large numbers."

  Some types of risk work with numbers better than others, because there are more numbers involved.  For example, everyone dies eventually, so companies have lots of data available for life insurance figures.  The statistics show the probability of death according to sex, ages and even professions.  Other types of loss are harder to predict.  When the health insurance industry began to offer protection against a nursing home confinement, determining possible losses was a guessing game because they had no real data to look at.  Although some people had been in nursing homes, figures were sparse and no one could be sure those figures that did exist were accurate.  Therefore, the early policies were written to greatly favor the insurance companies rather than the consumers.

  While risk, in its simplest form (exposure to danger or adversity) is easy enough to understand, when risk is applied to the insurance field, it becomes more complex.  When insurance is involved not only are we looking at exposures to loss, but also what it will cost to cover those exposures while maintaining profit, company growth, consumer satisfaction, and buyer interest.

  Insurance companies get lots of static about wanting to make a profit, but I don’t see too many companies anxious to operate at a loss.  I also haven’t seen insurance companies bailed out by the government the way the savings & loan industry was.  In fact, the insurance industry is one of the highest government regulated industries in our country.

Two Basic Types of Risk

  The insurance industry tends to tie risk and the possibility of financial loss together.  The chances and types of risk may be divided into categories.  There are basically two types of risk:

1. fundamental risk and particular risk

2. pure and speculative risk.

First: Fundamental and Particular Risk

  While fundamental and particular risk are linked together as are pure and speculative risk, each one is specific and separate.  A fundamental risk is a type of risk to which society in general (or at least a large number of people) are exposed to in a single occurrence.  A particular risk is one to which relatively few people are exposed to in a single occurrence.  Sometimes it can be very difficult to make a distinction between the two types of risk.  A recession is a risk to a large portion of society so that would be a fundamental risk, whereas investors who contribute to a specific project are involved in a particular risk because only those investors are exposed to that particular loss.

  Some types of risk seem to have properties of both fundamental and particular risk.  This may especially be true when it comes to disability insurance.  Particular risks, since they involve small numbers of people, are easier to insure.

Second: Pure Risk and Speculative Risk

Pure risk is a chance of financial loss which does not offer a chance of financial gain simultaneously.  Pure risks tend to be logical: either loss or no loss.  There is either a loss from an accident or there isn’t.  Pure risk is sometimes described as a loss or no loss situation.  There is never any gain with pure risks.

  A speculative risk, on the other hand, does offer the chance of both financial loss and financial gain at the same time.  With speculative risks, the person involved is taking some type of action which purposely exposes them to the possibility of a loss.  There are two elements involved in speculative risks:

1. There is a chance for gain as well as loss,

2. The individual usually creates a speculative risk for themselves by their own intentional actions.

  There are many types of speculative risks including such things as gambling and some forms of investing.  Between pure and speculative risks, pure risks are more easily insurable.  In most insurance matters, those risks with a low frequency and high severity lend themselves best to insurance coverage.  For example, a consumer buys insurance because he fears a loss due to a home fire.  It would be a “pure risk” because there is either a loss or no loss.  Unless an illegal activity, such as arson, were involved there would be no case for gain, merely loss.  On the other hand, if arson were involved what would normally be a pure risk becomes a speculative risk.  The owner of the policy is entering into a situation knowingly where he has a chance for both gain and loss at the same time.  He is purposely burning his home or business with the hopes of collecting on his policy.  If he collects he has made a gain.  On the other hand, if he is arrested for his illegal activity, not only will he not collect, he’ll lose the building he burned plus face jail time.  This policy owner has turned a pure risk into a speculative risk.

Gambling is a speculative risk that is not generally insurable.

Reading the Policy

  When it comes to insurance policies, many people have heard the saying "What the big print giveth, the little print taketh away."  Actually, this saying is not true.  Most states have laws requiring that “conditions” and/or “exclusions” be in type at least as large and clear as the statements of coverage.  In some cases, the type must be larger or in boldface type.

  Unfortunately, an agent would have a difficult time convincing a policyholder whose claim has been denied that this is true.  Few policyholders ever actually read their policies.  The insured often first realizes that their policy does not cover everything when a claim is denied.  It is at that point that an insurance agent or an insurance company is typically accused of “hiding behind small print.”

  All coverage under any insurance contract is subject to some type of limitations.  It is very important that insurance agents outline those limitations.  Every agent has met the client that refuses to be informed.  No matter how much a limitation is explained, they still expect everything to be covered.  Aside from those few who refuse to understand, most consumers do want to understand their policies.  The agents in the field should also want their clients to understand.  It prevents a lot of unnecessary stress when consumers understand not only what they did purchase, but also what they did not.

  The term “risk” may be used in many different ways.  Simply put, risk means exposure to danger or adversity.  When investments are involved, risk is generally defined as uncertainty concerning loss.  The two key words here are “uncertainty” and “loss.”  It is important to understand that risk is connected to the uncertainty, not to the loss itself.

The basic function of insurance is to transfer risk to another entity: themselves.  It is the job of insurers to know what amount of risk they are assuming by the transfer.  The accuracy with which losses may be predicted is the measure or degree of risk.

 There is some amount of social risk as well as financial risk.  Generally speaking, most people try to avoid most risks in their lives.  The average person would not cross a street against heavy traffic, for example.  Past such daily risk avoidance, however, fear of risk has an economic price.  Risk may discourage investors and can affect how financial resources are placed.  Poor areas of cities often experience this.  As an agent, you may find that your companies do not like to place insurance in certain areas that experience high rates of claims.  Those claims may be tied to low economic factors, the density of population or many other factors.

  Policies written by property and casualty agents experience a different kind of rejection than life and health agents do.  Life agents are only concerned with the likelihood of death when they write an application.  Will the guy filling out the application live a normal life or die prematurely?  This is based on several factors, but none of those factors usually take into account where he lives or what his income is.

  The agent writing a policy for automobile coverage will be faced with a different set of rules.  Where the consumer lives will certainly be a factor since rates are determined by geographical areas.  The crime rate in the applicant’s neighborhood will be considered if the policy covers vandalism or theft.  Some policies will take into consideration income if arson or illegal claim submissions could be a possibility.  Of course, these are the underwriter’s considerations, not the agent’s.  Health insurance underwriters may consider the applicant’s personal address, if allowed by state law, in areas where there are high claims due to such things as AIDS.  In a health application the underwriters are able to order blood tests or other medical procedures to minimize their concerns.  This is not available to the underwriters of an auto policy.  Each type of policy poses different concerns for the underwriters.

  Insurance does not completely eliminate risk because achieving an infinite number of exposure units is not possible.  One may always expect some deviation of actual results from expected results.  Certainly statistics, upon which the predictions are based, can never be perfect either.  Even if the statistics used for predictions were absolutely accurate, there is no reason to believe that tomorrow's losses will exactly duplicate yesterday’s losses.  Therefore there will always be uncertainties in predicting insurance losses.

  This is especially true as neighborhoods change their makeup.  A neighborhood that had experienced high rates of vandalism five years ago may experience little vandalism as working families move in and push out the elements that caused the problem.  Of course, other types of claims might develop, but the ones that underwriters previously expected and used for underwriting may no longer be accurate.  Because underwriters must remain as accurate as possible, insurers keep records on such things and change their underwriting procedures when it seems that standards necessary to underwriting have changed.

End of Chapter 2