If you are looking for insurance cover for your business, you would expect your insurance provider to protect you against all the business risks under the sun, right? However, the truth is that every risk is not insurable. Insurance coverage is never designed to cover anything and everything.

You have every reason to feel disappointed, but that's how things work in the insurance sector. Please understand that just like any other business, insurance providers also need to earn profit to survive. This is why they only cover risks that are deemed ‘insurable’. These are the risks that enable them to earn a profit.

In this article today, we are going to discuss the elements and types of insurable risks. After going through this blog, you will have a fair idea of what to expect from the insurance converges you are considering.

Here we go!

Let’s start with the very basics first!

How to define risk? How are they considered 'insurable'?

From the business point of view and keeping insurance in mind, risk primarily refers to two things. Firstly, the uncertainty resulting from the possibility of an event(s) occurring. Second, the potential for damage or injury to individuals or property to whom an insurance policy applies.

Simply put, an insurer will consider a risk to be insurable if it can charge a premium that covers potential claims and operational expenditures while still earning a profit. In the same context, please understand that the risks your business can or prefers to transfer to an insurance provider are generally those that could lead to considerable loss. These risks are considered and classified by insurance providers as ‘insurable’, depending on whether they are ‘pure risks’ or ‘speculative risks’.

Typically, insurance companies cover pure risks ( also called ‘event risks’). These are the risks that have no chance of a positive outcome—either something unpleasant will happen or nothing will happen at all. Major property damage risks, such as fires, floods, hurricanes and earthquakes are the most common instances in this category. These risks are usually considered insurable. Most pure risks are classified into three types-

  • Personal risks- These risks influence the insured person's earning capability
  • Property risks-These risks influence the property  of the insured person or a third party
  • Liability risks - Risks that cover losses arising from social interactions(for example, litigation)

Speculative risk involves the probability of loss, profit, or nothing happening at all. Investments and gambling are the most common instances of speculative risk. Speculative risks are not considered insurable in the traditional insurance market.

Furthermore, other forms of business risks are judged uninsurable by insurance providers. This is because, in these risks, the possibility of a loss outweighs the possibility that it will not occur. For example, property deterioration caused by wear and tear (due to a decision not to maintain the concerned property) or loss of income owing to market fluctuations are normally not insurable. With sufficient "controls" in place, the risk of such a loss can be eliminated or at least managed.

What are the elements of insurable risk?

Most insurance companies only cover pure risks or the risks that contain the majority or all of the essential elements of insurable risk. In this section, we will discuss some prominent elements-

  1. Loss cannot be catastrophic

Standard insurance does not cover catastrophic risks. It may seem unusual to find a catastrophe exclusion included among the essential features of an insurable risk. However, it makes sense if we consider the definition of catastrophic in the insurance industry. Remember that insurers must make a profit in order to stay afloat in the market. As a result, the degree of what each insurer considers catastrophic will differ. In brief, a catastrophic risk for an insurance firm is any form of loss that is so widespread, costly, or unpredictable that it would be unreasonable to provide coverage for it.

Don’t get confused! Larger catastrophic risks can still be considered insurable. However, only by insurers who feel they can accurately evaluate the risk of loss and charge appropriate premiums for doing so. In fact, some insurance providers specialise in catastrophic insurance. Natural disasters such as earthquakes, hurricanes and acts of war are examples of catastrophe risks.

Catastrophic risk can be classified into two types. The first type occurs when all or a subset of a risk group (such as the policyholders in that type of insurance) are exposed to the same incident. Nuclear fallout, hurricanes and earthquakes are examples of this type of catastrophic risk. In the second type, those risks involving any unpredictably substantial loss of value, not anticipated by either the policyholder or the insurer, are included. The terrorist attacks in Mumbai in November 2008 were perhaps the most prominent example of this type of catastrophic event.

2. Defined and measurable losses

For a loss to be insured or covered, the policyholder must show a concrete proof of loss, usually in the form of invoices in a measured quantity. It is not insured if the magnitude of the loss cannot be calculated or completely identified. An insurance company cannot produce a realistic premium cost without this information. The bottom line is that the losses should be fairly predictable and measurable in terms of money. For this reason, tension and loss of peace of mind can't be indemnified.

3. Statistically predictable losses

If an insurer is unable to predict anticipated losses statistically, it can't adequately evaluate possible losses. In order to determine premiums, insurers prefer a predictable loss. If a loss rate is unpredictable, it is not likely to be in the interest of the insurer. They may refuse to cover that type of risk.

So, the question may arise - how can insurers arrive at a predictable loss rate? This part is taken care of by their actuaries. These are the professionals who use different statistical models and analyses to examine financial risk statistically, mathematically and financially. A few of those calculations eventually come down to the use of a huge database to forecast expected losses. For example, life and health insurance companies employ actuarial science and morbidity and mortality tables to predict losses across populations. Simply put, insurers try to predict how frequently specific losses will occur in future and the anticipated severity of these losses. Naturally, larger premiums will be charged for losses that happen more frequently and are more severe in nature.

4. Chance and random losses

To be insurable, a loss must be ‘accidental’ and must be unexpected in its exact impact and timing. In other words, it should be the result of an inadvertent act or one that happened purely by chance. In principle, it must be beyond the business's influence or control. Losses must also be random in nature, which eliminates the possibility of adverse selection. The adverse selection addresses scenarios in which buyers and sellers have differing information. Market participation suffers due to the availability of such asymmetric information.

5. Large number of exposure units

The entire theory of insurance is dependent on the law of large numbers. Hence,  the primary requirement for a risk to be insurable is that there needs be a sufficiently large number of homogenous exposures, to aggregate reasonably predictable losses. In case of such a risk, the lost data can be accumulated over time and losses for that particular group can be projected with some accuracy. The loss costs are subsequently distributed among all the insureds in the underwriting class. Furthermore, the insurance company's probabilistic calculations estimate a sufficiently large number of units in a distribution. The products are then priced accordingly.

6. Fortuity

This is related to the "known loss" approach, which insurers often apply to deny claims. They may refuse to cover a risk if the loss has already occurred or if the insured should have known the loss would occur when the policy was purchased. The point they would put forward is that the insured should have taken adequate precautions to mitigate the foreseeable loss.

  1. Insurable interest

The insured's relationship with the property insured must be such that the concerned property loss has a negative impact on the insured's finances. This relationship is known as insurable interest, and it is a component of insurance that has evolved over time. According to this principle, the insured must eventually demonstrate a strong enough relationship with the subject of the insurance such that the property damage directly affects the insured.

7. Determinable profitability distribution

The probability distribution of the occurrence of an adverse event is determinable. According to the principle of equivalence, this condition is required to establish a free premium. There is no way for an insurance firm to issue a cover if the distribution is not determinable.

8. Economically feasible premium

This is the final requirement of insurable risk which says that the premium should be economically feasible for the insured to pay. Furthermore, for the insurance coverage to be an appealing purchase, the premiums paid must be significantly less than the face value or amount of the policy. It should be sufficient to cause a 'win-win situation' for both the insurer and the insured.

Insurable Risk for Start-ups

Insurable risks for startups

While selecting a benefits package for your startup, please remember that even the most comprehensive insurance policies will not cover all the risks related to your business. As we have seen above, uninsurable risks will always exist. There would be risks that cannot be insured because they are either too likely, too costly, too catastrophic and too simply manipulated.

Let us assume you have purchased insurance to protect your startup from allegations of errors, omissions, malpractice, or negligence while delivering professional services to a third party.  If your startup makes a mistake leading to financial loss to the concerned third party, you would definitely expect the insurer to respond. Such a scenario is most likely to be covered by your insurance provider. Now, let's turn our attention to a different scenario. Your startup may experience losses as a result of consumers exiting because they were dissatisfied with your service. A loss of this nature would not be insurable as it is merely a speculative risk of doing business.

What should you do then? While purchasing business insurance, you must be aware of the risks to your startup, the coverage limitations applicable and how you manage the risk that may or may not be covered. If you are finding it difficult, you may deal with a broker who can assist you in identifying these risks, both insurable and uninsurable. He will also tell you about the risks that may or should be transferred, or managed differently otherwise. With this piece of knowledge at your disposal, you can negotiate the best coverage to cater to your unique objectives.

The footnote:

We hope the discussion above will help you understand the different elements of insurable risk. We have also discussed what it means for start-ups and how to consider it while negotiating insurance coverage. For the best recommendation on any insurance, you may contact BimaKavach. Here, you can get the best advice for any business insurance product in just 5 minutes.

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