Risk, Core Concepts for its Greater Understanding in Insurance

Risk, as explained in our recent post titled “Understand Risk and How Insurance is used to address it”, is all around us. It is helpful to know and understand the terminology used to describe risk and its adverse outcomes (known as losses) in the context of insurance.

Peril vs. Hazard

A peril is any characteristic or condition that may give rise to a loss (adverse outcome). A hazard is a condition that influences a peril, increasing the likelihood of a loss occurring. Examples of perils are fire, lightning, collapse of a structure, etc. All of which may give rise to a loss. A hazard is anything that increases the likelihood of a loss occurring. Some examples of hazards are: storing flammable materials near an open flame, keeping property outside during a thunderstorm, using poor construction methods in erecting a structure, etc. Hazards can be described as physical hazards and moral hazards. Physical hazards are characteristics that act on a peril to increase the likelihood of a loss. Moral hazards describe the insured’s attitudes to risk and how his/her actions may increase the likelihood of a loss occurring.

Moral hazard may be evident when an insured is not as careful in protecting his property because he knows that he will be indemnified (compensated) by an insurance policy for the losses that he suffers. On the extreme side of moral hazard, an insured may be the cause of the loss itself, examples include instances where an insured sets fire to his own property for the sole purpose of collecting an insurance settlement (payment). When accepting risk on behalf of its insureds, an insurer will price the insurance coverages they offer according to the level of perceived risk. If the insurer perceives greater risk due to the perils being insured against and the hazards that act upon those perils, then a higher premium will be charged to provide coverage. If the risk is deemed to be to excessive, the insurer will abstain from writing the business (i.e. providing insurance coverage) at any price. Excessive risk may turn an insurance transaction extremely expensive for the insured, perhaps even make it uninsurable in which case the client is unable to find an insurance company willing to accept the risk.

Frequency vs. Severity

Loss frequency describes the quantity of losses that may be suffered during a given period. Loss frequency can range from low frequency where losses are few and far between and high frequency where losses are more constant and common. Loss severity is more a qualitative measurement which quantifies the impact of the loss. Loss severity can range from low severity where the effects of the loss are slight to high severity where the loss results in catastrophic consequences. It is important for an underwriter to understand the interplay between the frequency and severity of losses that may be brought about by an insured’s operation.

• Low frequency, low severity: this scenario poses the lowest level of risk and should therefore result in the least amount of loss during any given period. Individuals and businesses may choose to retain (keep for themselves) the risks that fall under this category. Insurance may also be purchased for a cost that will be commensurate to the level of risk ceded to the insurance company.

• High frequency, low severity: this scenario poses more risk than above because the accumulation of low severity losses can add up to represent a significant figure which may in turn put stress to the company’s budget. Insurance companies usually do not want to be involved in resolving many claims for an insured because each claim settled bears expenses beyond the amount that the insured will be indemnified. Investigating the claim, hiring adjusters and/or lawyers and other expenses can be significant and at times exceed the amount that the insured may receive to settle the claim. The accumulation of losses will have a detrimental effect on the perception of the risk therefore, to make insuring a risk viable, insurers will impose franchises and deductibles to ensure that they are only called upon to indemnify the insured after a loss passes a specified threshold. The insured will retain all losses below the deductible and the insurer will act on those losses that exceed the deductible.

• Low frequency, high severity: this scenario is the ideal area for insurance to play a role as a risk management tool. Low frequency high severity losses can be difficult to manage as said losses may come as a surprise to the insured. One loss, if severe enough, can make a company insolvent (i.e. fail). Insurance is a great way to deal with low frequency, high severity losses because the uncertainty of suffering a high severity loss at any time during the policy term will be exchanged for the certainty of an insurance premium payment and the insurer’s promise to pay for losses covered under the insurance contract.

• High frequency, high severity: this scenario is the most difficult to deal with from a risk management standpoint. High frequency, high severity losses are unattractive for insurance companies to accept as the insurance policy will be expected to indemnify the insured for constant high value losses. Insurers will not write a risk with the above characteristics and if for some reason insurance coverage becomes available, it would be very expensive to insure. The best way to deal with this risk profile is to apply risk management techniques to reduce either the frequency or severity of losses thus generating a different profile which may be more attractive for insurers to cover.

Understanding how to describe risk and how an insurance company may perceive it will go a long way towards improving the transaction of insurance business. For risk transfer to take place prosperously, both parties, the insurer and the insured, must see value in the transaction beyond just chance or good luck. Insurers must see that the insured is a person of good moral character who is seeking coverage to protect himself and/or his assets. Whatever risk is being transferred to the insurance company must also be one that is understood by both parties and whose treatment will fall within the expectations of the conditions under which the risk is transferred. It is said that the insured should treat any property and/or other risk he insures as if no insurance was in place meaning that the insured should take the best possible care of whatever is being insured to not prejudice the insurer and expose him to a greater level of risk.

Risk will continue to be ubiquitous but with sound risk management techniques and understanding some of the characteristics of risk described above, win-win solutions can be found by the parties involved in an insurance transaction. Solutions that in the long term can help ensure the insured’s survival following adverse events and the insurer’s continued growth to continue to offer insurance products to protect its clients.