Understanding Insurance

3. Holding hot potato: transfer or avoid

We closed second article of this series with three choices of actions available in dealing with risks, namely to ignore, to retain and to transfer. Earlier part of the same article discussed that risk can be divided into four categories based on a combination of frequency and severity. Let’s continue our discussion to the risks of category 3 and 4.

Transferring risks

The risk of category 3 has a low frequency (rare to very rare) to turn to loss, but if it happens, the consequences can be fatal and/or the financial losses could be very high. The risk of one’s house being burned in the fire or the car involved in a collision is an example of the risk of this group 3. Because it is rare, the he/she cannot make a prediction of the total loss in a certain period of time. On the other hand, he/she should not neglect this risk because the consequences could be very severe. Thus, ignoring or retaining is not an appropriate choice for this type of risk.

Transferring is a reasonable option for this type of risk. But, who wants to accept? Many will be happy to receive money transfer, but transfer of potential disaster? Seriously?

Now it is time to see the role insurance company can play. Insurance companies are actually those who “volunteer” themselves to receive transfers of uncertainty and bear the financial losses incurred if the risks really turn up to be disaster. Well, it is not really a volunteerism, as its willingness is not free. Insurance companies will ask for a fee called premium. The amount of this premium has to be significantly smaller than the potential of loss that can be brought by a risk, otherwise insurance will lose its relevance. There is no point getting rid of the risk if certain upfront cost is higher than or almost the same as uncertain maximum loss that we may suffer.

Next question is, why would the insurance company be willing to take over the risk of the other party for a much smaller fee than the potential loss? The key to the answer is in ability of insurance companies to predict the amount of loss they have to bear at certain time or period of time.

Where do insurance companies obtain the ability to predict the amount of losses in the future from, especially when the frequency is low? Do they hire a fortune teller or use magic or something?

Source: http://www.pramata.com

Indeed, the very problem of low frequency that the insurance company solve. What they do is increasing frequency by collecting similar risks from many risk owners. The larger number of risks the better because the accuracy of their prediction increase. This is so-called the law of large numbers that says when we estimate unknown parameter of a population through sampling, the statistic (estimation) will be closer to the actual value parameter as the sample size get larger.

So, in a nutshell, insurance companies are able to calculate the expected amount of loss through pooling of risks and utilizing the law of large numbers. By adding other costs such as acquisition and management expenses as well as profit margin, the company arrives at premium to charge to each risk owner (the insured).

Ok, what if the insurance company’s calculation is wrong, when total loss turned out to be far greater than the estimated amount? This is a very interesting topic in fact, we shall discuss it in the next opportunity when we touch the topic of reinsurance.

Avoiding risks

Now come time we discuss the risk of final category, category 4, which is the risk that frequently turn to loss and its consequence is severe. Compared to the other three, the risk of this type is clearly the most dangerous. This is an extreme category and not even easy to find an example, maybe because people generally try to avoid being in this situation.

The risk of flooding for residents who live on the riverbank may be a usable example. In rainy season their homes are always flooded and water bring damage to buildings, furnitures and other contents. As floods arrive so often, residents learn from experience how to reduce the impact. For example, because floods usually inundate the first floor, all electronic equipment, important documents and the most valuable objects are placed on the second floor.

Some jobs or hobbies are dangerous, to the extent they can be categorized as risk type 4. Stuntman, matadors (bull fighter), circus players, motorbike riders are a few examples. Although, you may argue that as a person’s skills increase, they can turn to risk type 3, because the frequency of accidents decreases.

Will the insurance company accept transfer risk of type 4? Generally no, they don’t. Although high frequency allows better prediction, the magnitude of the losses of each event makes the risk of this type not economical to be managed through an insurance scheme. The premium that needs to be paid upfront by the risk owner becomes too high, relative to the potential loss itself. That is why insurance excludes risks associated with hazardous work or hobbies.

When risk cannot be transferred to another party, the best solution for this type of risk is to avoid it. Moving away from the banks of the Jakarta river, stopped being stuntman, retired from the bullfighter or stopped motorbike racing.

P.S. For Bahasa Indonesia version of this article, click https://dkhairat.com/2019/01/26/mengerti-asuransi-3-siapa-mau-menerima-transferan-potensi-bencana/

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