Understanding Risk in the Insurance Industry
Risk is the fundamental concept underpinning the entire insurance industry. Without risk, there would be no need for insurance. Risk is defined as the chance of loss or damage, an uncertain event that may occur and result in economic imbalance for the individual or entity that suffers it.
Characteristics of Insurable Risk
For a risk to be considered insurable, it must typically meet the following characteristics:
- Be possible events (they may or may not happen).
- Be lawful acts (within legal boundaries).
- Be quantifiable (the potential loss can be measured).
- Appear random and sudden (unforeseen and unexpected).
Classification of Risks
Risks are generally classified in two primary ways:
- By the Nature of the Loss: Pure Risk or Speculative Risk.
- By Origin or Scope: Catastrophic Risk or Individual/Personal Risk.
Speculative Risk
Speculative risk is where there is a possibility of gain, loss, or no change. Individuals or entities consciously undertake these risks with the aim of obtaining a profit, but they also bear the danger of losing. Examples: Playing the lottery, where one can win, lose, or receive a refund.
Pure Risk
Pure risks are individual dangers inherent in us that constantly threaten us, as there is always the possibility that an event will occur that results in economic loss. Example: The economic imbalance that may occur to a woman due to the loss of her husband.
Inherent Risk
Inherent risk is a risk that, by its nature, cannot be separated from the situation where it exists. It is intrinsic to the situation and specific to each company based on its activity.
Built-Risk
Built-risk is inherent in an activity but arises from certain behaviors of a worker who takes risks to achieve something they believe is beneficial for themselves and/or the company. This could include gaining time, finishing work early, standing out, or impressing colleagues.
This classification (Individual/Personal and Catastrophic) considers both the magnitude of the loss and the number of people affected.
Individual or Personal Risk
This type of risk affects a particular person or a small group. Example: The death of a breadwinner.
Catastrophic Risk
A catastrophic risk is an extraordinary event, often natural, of high intensity and abnormal damage potential. Example: Losses resulting from a hurricane.
Alternative Solutions for Risk Management
Various strategies can be employed to manage risk:
- Reduction
- Prevention
- Retention (Hold or Assume)
- Distribution
- Transfer
- Elimination
Components of Risk
Risk has two primary components:
- Hazard: The probability of the event occurring.
- Vulnerability: The probability that the event results in damage.
Solvency in Insurance
Solvency is one of the most significant objectives for an insurer, as it represents the company’s ability to meet its obligations. There are several reasons why solvency is crucial for insurers.
Types of Solvency
- Static Solvency: The amount or reserve a company holds to meet existing obligations.
- Dynamic Solvency: Considers equity risk, future obligations, company investments, payroll, and other factors.
Fundamental Objectives of Solvency Monitoring
- To monitor insurance companies effectively.
- To ensure a stable insurance market for policyholder protection.
- Minimum Capital Requirement: The minimum amount a company must hold to meet its obligations.
- Coverage: The actual assets a company possesses to meet its obligations.
Types of Risks Analyzed by Risk Theory
Technical Risks
These risks are inherent to the insurance operations themselves:
- Investment risk
- Inadequate premium valuation
- Technical reserves
- Reinsurance
- Cost of operation
- Large losses or catastrophic accumulation
- Growth and liquidation challenges
Investment Risks
A specific category under technical risks, focusing on financial aspects:
- Depreciation
- Liquidity mismatch
- Market fluctuations
- Credit risk
- Investment valuation
- Participation in financial institutions
- Derivatives
Non-Technical Risks
These risks are not directly related to the core insurance operations but can still impact the company:
- Management issues
- Risks related to guarantees to third parties
- Third-party accounts
- General business risks