The concept of risk
Risk exists when there is uncertainty about the future
There are two major type of risk:
Speculative risk – involves three possible outcomes: loss, gain, no change.
Pure risk – a risk that involves no possibility of gain.
Pure risk involves possibility of economic loss without the possibility of economic gain - is the kind of risk that can be insured.
The purpose of insurance is to compensate for financial loss, not to provide an opportunity for financial gain.
The practice of risk management involves identifying risk, assessing risk, and dealing with risk.
In order to eliminate or reduce our exposure to financial risk, we can ….
‘Avoid risk’ – by staying away from the risk. This is sometimes not effective or practical.
‘Control risk’ – by taking steps to prevent or reduce losses. In other words, reduce the likelihood of a loss or lessen the severity of a potential loss.
‘Accept risk ‘– by assuming all financial responsibility for that risk as in self insurance.
‘Transfer risk’ – by shifting the financial responsibility for that risk to another party, generally in exchange for a fee by purchasing insurance coverage. Life insurance companies sell insurance policies to provide financial security from personal risk – the risk of economic loss associated with death, poor health and outliving one’s savings.
‘Share risk’ with the community through cooperative and mutual protection as in al-takaful or khairat.
Managing Personal Risks through Insurance
Insurance companies use the concept known as risk pooling – losses are shared by large numbers of people who are all subject to such losses and the probability of loss is small for each person resulting in the cost to each person being relatively small.
Characteristics of insurable risks
Risks that can be insured must satisfy the following category.
The loss must occur by chance (cannot be totally predictable or controlled).
Death is certain to occur rather than by chance but the timing of death usually occur by chance.
The loss must be definite (the insurer must be able to determine when to pay policy benefits and how much the benefits should be).
Time (when) and amount (how much).
Contract of indemnity – the amount of policy benefit payable is based on actual amount of financial loss that results from the loss (determined at the time of loss) or on the maximum amount stated in the contract, whichever is less;
Valued contract – specifies the amount of benefit payable when a covered loss occurs, regardless of the actual amount of the loss incurred – face amount or face value.
The loss must be significant (the insured generally must suffer financial hardship as a result of the loss).
Losses that cause financial hardship to people.
The loss rate must be predictable (the insurer must be able to predict with reasonable accuracy the number and timing of covered losses that will occur in a given group of insureds).
The rate at which covered losses are expected to occur in a specified group of insureds.
The law of large numbers states that, typically, the more time we observe a particular event, the more likely it is that our observed results will approximate the ‘true’ probability that the event will occur
Mortality tables – charts that display the incidence of death, by age, among a given group of people.
Morbidity tables – charts that display the incidence of sickness accidents, by age, occurring among a given group people.
The loss must not be catastrophic to the insurer (the insurer must not be subject to catastrophic financial damage as a result of the loss).
‘Reinsurance’ – a type of insurance that one insurance company purchases from another insurance company in order to transfer risks on insurance policies that the ceding company issued. When a covered loss occurs, the reinsurer reimburses the ceding company for the portion of the loss that was reinsured;
‘Cede’ – to obtain reinsurance on insurance policies by transferring all or part of the risk to reinsurer
‘Retention limit’ – the maximum amount of insurance that an insurer is willing to carry at its own risk on any one life