CFP

Insurable Risks

Risks are generally divided into two classes: Pure risks and Speculative risks.

Pure Risks- these risks involve only the chance of loss, there is never an opportunity for gain or profit.
Examples: injury from an accident, loss of home from an earthquake.

Only Pure Risks are Insurable

Speculative Risks- These risks involve both the chance of gain or loss.
Examples: Gambling at the race track, or investing in the real estate market.

Speculative Risk is not Insurable

Elements of an Insurable Risk

• Loss must not be Catastrophic
• Loss must be Unexpected or Accidental
• Loss produced by the risk must be Definite and Measurable
• Must be a significantly large number of homogeneous exposure units to make the losses reasonable predictable

Risks can also be evaluated on an economic scale comparing static and dynamic risks:

Static Risks are the losses that are caused by factors other than a change in the economy (for example- hurricanes, earthquakes, other natural disasters)

Dynamic Risks are the result of the economy changing (examples- inflation, recession, and other business cycle changes). Dynamic risks are not insurable.

Practice Question:
Which of the following risks are considered insurable risks?
I. Static Risks
II. Dynamic Risks
III. Speculative Risks
IV. Pure Risks
V. Inflation Risk

A. I and IV only
B. II and IV only
C. I, IV, and V
D. I, II, III, IV, and V

Answer: A
Only pure risks are insurable. Static risks are a type of pure risk that tends to occur with regularity- they can be insured against. Dynamic, Inflation, and Speculative risks are all uninsurable.

Practice Question:
Which of the following is an element of insurable risk?
A. The loss must be unexpected or accidental
B. The loss must be catastrophic
C. The loss produced by the risk cannot be measurable
D. The loss must be damage related

Answer: A
The loss must be unexpected or accidental to be an insurable risk. It cannot be catastrophic and it must be measurable and definitive.

Self-Insurance
Self-insurance is the process of an individual or company acting like an insurance company to cover its own risks. This involves evaluating a large number of similar potential losses, the ability to predict the overall losses with some degree of accuracy, and the establishment of a formal fund for future losses and their possible fluctuations.

Self-Insurance for both companies and individuals has its pros and cons:
Advantages:

• Avoid the cost of premiums for commercial or personal insurance
• Reserves can be invested in short-term money market instruments and later used by the company or individual when the insurance is no longer needed

Disadvantages:

• Company/individual is exposed to a catastrophic loss
• Services provided by the insurance company are assumed
• Income taxes may be due on the interest/profit from the reserve cash