Insurers distinguish between two types of risk: speculative risk and pure risk. Speculative risk offers both the potential for gain and the potential for loss. People who invest in the stock of companies, for example, take speculative risk. An increase in stock prices produces a gain, while a decline in stock prices produces a loss. Pure risk, by contrast, creates the potential only for loss. Although pure risks do not necessarily result in losses, they never result in gains.
Historically, insurance dealt only with pure risks, and most people still buy insurance to cover pure risks. No one, for instance, experiences a gain when they go a full year without an auto accident. However, some insurance companies now help businesses finance large losses including those incurred on speculative risks, such as the international exchange of currency. Also, in the 1990s financial markets and some professions outside insurance, such as the field of environmental impact and damage assessment, began to expand into risk management for the first time.
III | | The Importance of Insurance |
Insurance benefits society by allowing individuals to share the risks faced by many people. But it also serves many other important economic and societal functions. Because insurance is available and affordable, banks can make loans with the assurance that the loan’s collateral (property that can be taken as payment if a loan goes unpaid) is covered against damage. This increased availability of credit helps people buy homes and cars. Insurance also provides the capital that communities need to quickly rebuild and recover economically from natural disasters, such as tornadoes or hurricanes. Insurance itself has become a significant economic force in most industrialized countries. Employers buy insurance to cover their employees against work-related injuries and health problems. Businesses also insure their property, including technology used in production, against damage and theft. Because it makes business operations safer, insurance encourages businesses to make economic transactions, which benefits the economies of countries. In addition, millions of people work for insurance companies and related businesses. In 1996 more than 2.4 million people worked in the insurance industry in the United States and Canada.
Insurance companies perform a type of monetary redistribution—they collect premiums and eventually redistribute that money as payments. Depending on the type of insurance, redistribution can take anywhere from a few months to many decades. Because of this delay between collecting and paying out funds, insurance companies invest their funds to bring in extra revenues. Such investments help businesses and governments finance their operations, and profits from those investments support the operations of insurance companies. With these investment earnings, insurance companies can keep rates much lower than would otherwise be possible.
Not all effects of insurance are positive ones. The possibility of earning insurance payments motivates some people to attempt to cause damage or losses. Without the possibility of collecting insurance benefits, for instance, no one would think of arson, the willful destruction of property by fire, as a potential source of money.
To help individuals and businesses manage risk, providers of insurance must have ways of determining what kinds and degrees of risk different people and businesses face. To do this, insurers rely on the basic principle of grouping together similar risks. By examining the risks faced by a variety of individuals and businesses, insurers can establish common risk profiles (patterns of characteristics). With this information, an insurer can quickly determine what kind of insurance to offer someone applying for a policy, and how much it will cost to insure that person’s risks.
Every insurer employs underwriters to assess the insurance risk posed by applicants for insurance, and to group applicants into classes based on similar risk profiles. For example, companies that insure cars and their drivers categorize teenage drivers as a class separate from older drivers. Studies have shown that teenagers have many times more crashes than other age groups.
Individuals or businesses whose profiles indicate a statistically average class of risk or lower can usually easily qualify for insurance at reasonable prices. Those whose profiles indicate higher than average risk must pay higher prices for insurance, or they may have a difficult time getting insured at all. When applicants present too much risk, all insurance companies may decline to insure them.