Insurable Risks

While the definition presented above indicates what insurance is from the point of view of the policyholder, there are many risks of economic loss that no insurance company is willing to accept.  From a risk management perspective the ideally insurable risk is a  pure, static and particular risk.  From the viewpoint of the insurer, certain conditions must exist before insurance is possible (Table 8.1).The fundamental requirement for the existence of insurance contracts is the existence of a large number of similar loss exposures.  What makes insurance feasible is the pooling of many loss exposures, homogeneous and independents, into classes (classes of business), according to the theory of probabilities (the law of large numbers).  Even if the probability that an event will occur is accurately known, the statistics do not apply to an individual exposure or even a  small group. Similarly, it may be difficult for an insurance company to cover catastrophic risks such as earthquakes, flood, or war damage, because it may affect a large number of insureds at once.

The pooling of loss exposures and the reduction of the risk of variation from the expected outcome is one reason insurance companies can issue insurance contracts to individuals unable to diversify themselves the risks. Another reason is that insurance companies can diversify the residual risk of each class of loss exposures by combining several classes of business into a portfolio.  An insurance
company cannot have all of its eggs in one basket.

The law of large numbers, though necessary for insurance, is not sufficient.  A further condition is the possibility to determine exactly the nature of the loss exposure and to be able to calculate, either by estimating the underlying probabilities, or by judgment, the frequencyand the severity of the possible loss. Moreover, even if the cost of insurance can be calculated, insurance is not practical if the premium that is determined by the insurer is too high and as a consequence the individual (or firm) is unwilling to pay for it.