Elements of insurable risk, adverse selection, the law of large numbers, and reinsurance

Why some risks can be insured and others cannot

Insurance works by pooling: many people each pay a relatively small, certain premium, and the pool pays the relatively few who suffer a covered loss during the policy period. That arrangement only holds together if the risk being pooled has certain characteristics. Insurers insure pure risk (where the only outcomes are loss or no loss), not speculative risk (where you could also gain, such as gambling or investing in stocks).

The elements of an insurable risk

A risk is generally considered insurable when it has these features:

• A large number of similar (homogeneous) exposure units. The insurer needs many comparable people or properties so that losses can be predicted for the group.
• Accidental (chance) loss. The loss must be unexpected and outside the insured's control. Intentional losses are not insurable.
• Definite and measurable loss. It must be possible to tell when a loss happened, what caused it, and how much it is worth.
• Predictable (calculable) loss. The insurer must be able to estimate how often and how severely losses will occur, so it can charge an adequate premium.
• Not catastrophic. The loss should not strike a large share of the exposure units at the same time. War and nuclear hazards are commonly excluded for this reason.
• Economically feasible premium. The premium must be affordable relative to the possible loss. Very small, frequent losses are usually better retained than insured.

Many textbooks also add that the exposures should be randomly selected, which leads directly to adverse selection.

Adverse selection

Adverse selection is the tendency of people who are more likely to have a loss to seek insurance, or to seek more of it, than people who are less likely to have a loss. A person who knows a storm is coming, or who already feels ill, has an obvious incentive to buy coverage. If the insurer cannot detect this, its pool fills with worse-than-average risks, losses exceed what the premium was built to pay, and rates rise for everyone.

Insurers protect against adverse selection through underwriting, within the limits the law sets for each line: applications, medical information, inspections, waiting periods, pre-existing condition limits, and charging premiums that match each risk class. For individual and small group comprehensive (major medical) health insurance, federal and New York law require guaranteed issue and bar pre-existing condition exclusions and rating by health status, so those plans rely more on set enrollment periods. Underwriting is how an insurer tries to make the risks it accepts look like the average risks its rates assumed.

The law of large numbers

The law of large numbers says that the larger the number of similar exposure units, the more closely actual losses will match the losses that were predicted. An insurer cannot know whether one particular house will burn this year, but with tens of thousands of similar houses it can predict, quite accurately, how many will. This is why a large number of homogeneous units is the first element of insurability, and it is the foundation of premium rates.

Reinsurance: insurance for insurers

Reinsurance is an arrangement in which one insurer transfers part of the risk it has written to another insurer. New York's Insurance Law describes the parties this way:

• The ceding insurer is the company that originally wrote the policy and passes part of the risk on.
• The assuming insurer (the reinsurer) takes on an obligation to the ceding insurer that is triggered only when the ceding insurer itself incurs a loss under the policies it wrote with third persons.

The policyholder deals only with the original insurer. The ceding insurer stays fully responsible to its insured, even if a reinsurer fails to pay. Reinsurance is a contract between insurers.

Reinsurance lets an insurer spread catastrophic exposure, write larger policies than its own capital would safely support, stabilize its results from year to year, and protect its surplus. Common forms include:

• Treaty reinsurance, an automatic agreement covering a whole class of business, versus facultative reinsurance, negotiated one risk at a time.
• Proportional arrangements (such as quota share and surplus share), where premiums and losses are shared in an agreed ratio, versus excess of loss, where the reinsurer pays only losses above the ceding insurer's retention.
• When a reinsurer itself reinsures part of what it assumed, that is called retrocession.

New York also recognizes an accredited reinsurer: a reinsurer not authorized to do business in New York that shows it meets the state's solvency standards and holds a certificate of recognition from the superintendent, so a ceding insurer can be allowed credit for reinsurance placed with it.

Exam tips

• Insurers insure pure risk, not speculative risk.
• Adverse selection is controlled by underwriting.
• Law of large numbers: more similar units means more accurate loss prediction.
• Ceding insurer gives risk away; assuming insurer (reinsurer) takes it. The insured has no direct contract with the reinsurer.