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The Importance of Property & Casualty Insurance — Part II

July 18, 2012

Insurance is a form of risk management primarily used to hedge against the risk of contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss from one entity to another, in exchange for payment. Insurance pools funds from many to pay for the losses that some may incur. The insured entities are therefore protected from risk for a fee, with the fee being dependent upon the likely frequency and severity of the risk. Not all risks can be insured against; risks that can be insured typically share seven common characteristics:

  1. Large number of similar exposure units: Since insurance operates through the pooling of resources, the majority of insurance policies are provided for individual members of large classes, allowing insurers and insureds to benefit from the law of large numbers in which predicted losses are similar to the actual losses.
  2. Definite loss: The time, place and cause of loss due to the risk can be fixed and determined.
  3. Accidental loss: The event that triggers a loss should be unforeseen, and outside the control of the beneficiary of the insurance.
  4. Large loss potential: The potential size of the loss must be meaningful from the perspective of the insured, or there is little incentive to insure. Insurance premiums need to cover both the expected cost of losses, plus the cost of issuing and administrating the policy, adjusting losses, and supplying the capital needed to reasonably assure the insurer will be able to pay claims.
  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 the protection offered, it is not likely that the insurance will be purchased.
  6. Calculable loss: There are two elements that must be at least estimable, if not formally calculable: the probability of the loss, and the attendant cost.
  7. Limited risk of catastrophically large losses: Insurable losses are ideally independent and non-catastrophic, meaning the losses do not happen all at once and the individual losses are not severe enough to bankrupt the insurer. In commercial fire insurance it is possible to find single properties whose total exposure value is well in excess of any individual insurer’s capital constraint. Such properties are generally shared among several insurers, or insured by a single insurer who transfers some of the risk into the reinsurance market.

 

Read Part I and Part III of this series.

 

Article by: Mark A. Wogsland, Field Representative

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