Previous articles in the series of ‘Understanding Insurance’ have discussed what risk is, how it is grouped based on frequency and severity, at a glance how insurance works based on the principle of pooling of risks and law of large number and also briefly alluded to concept of hazard .
We continue now to discuss other three important concepts in insurance, namely pure risk, insurable risk and basic principles of insurance. This discussion is very important, especially prior to discussing takaful or Islamic insurance, because it shall provide a correct and fair basic understanding on conventional insurance, in particular about some guards to keep insurance away from gambling.
Let’s begin by defining what insurance is. Insurance is a risk transfer mechanism from a risk owner, also known as an insured, to other party, in this case an insurance company or insurer. Under this contract, the insurer agrees to compensate financial loss suffered by the insured, caused or brought about by certain risks, subject to exclusions, terms and conditions. On the other hand, the insured agrees to pay a sum of money, i.e premium, in return to the willingness of the insurer to bear the transferred risk.
Why insurance and gambling are so close? Because both have the same raw material i.e uncertainty. This raw material is expressed, analysed and processed using the same tool, namely probability theory.
Having said that, gambling and insurance use different terms for uncertainty. Insurance calls it “risk” and it always has negative connotation, in relation to disasters and losses. Meanwhile, gamblers prefer to use the term of “chance” or “opportunity”, which connotes more positive and optimistic because it highlights the possibility of profit, without denying the other side of the coin i.e loss.
The proximity of insurance and gambling, and the fact that insurance is very vulnerable to abuse by speculators and those who look for a quick profit has been realized since the early development of conventional insurance in England in the 17th century. This consciousness has led to development of some basic concepts aimed at strengthening and protecting noble concept of insurance from abuse or misuse. Among them are the concept of pure risk, requirements for risks to be insurable, and basic principles of insurance. These basic concepts have been integrated into British law, both in thousands of case laws and written laws, among which the most famous is the Marine Insurance Act 1906.
Let’s start with the first one, which is pure risk.
Pure risk vs. speculative risk
Risk (or chance) is grouped into pure risk and speculative risk. This dualism is based on possible outcomes from a risk. Pure risk has two possible outcomes: loss or break-even point. While speculative risk has the possibility of a third outcome, that is profit, in addition to loss and break-event point. In principle, only pure risk can be insured (insurable risk), whereas speculative risk is not.
We shall discuss other two concepts in the next article.