Insurance Definition of Risk

Written by jake lebrun
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Insurance Definition of Risk
Risk can mean uncertainty and loss. (money makes money image by Andrey Andreev from Fotolia.com)

"Risk" is a term used frequently in the insurance industry. Although the general meaning of such a common word is obvious to most people, the meaning for those working in insurance is more precise.

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General Meaning

Risk, in the general sense, means the likelihood of an event happening, and the severity of the negative consequences. Although some definitions, as in mathematics, might address the "risk" of beneficial events, the insurance industry regards risk as representing loss or damage.

Bear in mind that risk always involves uncertainty. Risk does not encompass expected or certain losses or expenses, rent, consumption of resources, or equipment wearing out after its expected lifespan.

Components of Risk

You can divide the concept of risk into two components. One is the likelihood of loss or damage. You can express this as a certain percentage chance of an event occurring, or a certain number per one thousand individuals who experience this event, or some similar metric.

The other aspect is the impact if such an event does occur. The product of these is the "expected value." Because we are discussing risk, the consequences are negative (expense), so the expected value is negative.

Insurable Risk

Insurable risk refers to "risk for which an acceptable probability of loss may be calculated, and which an insurance company might, therefore, be willing to cover," according to the Prentice Hall textbook "Understanding the Fundamentals of Business and Economics." A few features of insurable risk are a large number of similar cases, the ability to financially measure the loss, and the accidental nature of the loss.

Directions of Risk

You can describe risk in another way as well. "Downside risk is the probability and consequences of loss, damage or expense. "Upside risk" is the probability and consequences of not achieving an expected gain. If your wallet is stolen, that is downside risk. If your employer goes bankrupt and can not pay you for the week you just worked, that is upside risk. In one, you suffer a loss you did not expect. In the other, you do not realise gain that you did expect.

Risk Measurement

Insurance companies use their measurements of risk to set premiums. Specialists called actuaries determine the expected value (risk) of various endeavours, buildings, vehicles or other entities and determine how much money must be received by the company to ensure them.

Remember, while risk, by definition, involves uncertainty, it is "measurable uncertainty." We do not know which car will get into an accident, or which person will suffer a heart attack, or when or where.

But because actuaries do know how many vehicle accidents and heart attacks have taken place in the past, and under what general conditions, they can predict approximately how many are likely to take place in the future.

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