Now that we have understood the concept of risk and its classifications let us discuss the different criteria for insurable risk.
Law of large numbers
Life Insurance companies use the law of large numbers to estimate the losses a certain group of insured persons may have in the future. An actuary (the person who designs insurance products) uses statistics to look at losses that have occurred in the past and forecasts that in the future approximately two out of 100 policyholders will have a claim. Thus, if the company writes 100 life insurance policies, it may expect to pay two claims.
Also, the Insurance companies determine the average cost of claims over time, or loss severity. If the average claim resulted in the company paying ₹1 lakh, then the actuary will forecast that total losses for the upcoming year will be ₹2 lakhs (two claims at ₹1 lakh each).
The law of large numbers states that as the number of policyholders increases, the more confident the insurance company is, its forecasts will prove true. Therefore, insurance companies attempt to acquire a large number of similar risk profile policyholders (called a homogeneous group) who all contribute to a fund which will pay the losses.
An insurance company sets the rates of its premiums according to the number of claims it will expect to pay over the term of the policy.
Loss must be accidental or fortuitous loss
For a risk to be insurable, it should be accidental or of fortuitous nature because insurance is based on chance. You cannot insure an event which is bound to happen. There should be an element of uncertainty. So, a terminally ill person cannot be insured because he is certain to die soon.
A normal healthy person is also certain to die but the timing is uncertain so he/she can be issued a life insurance policy. When death would actually happen, some may die at 30 some at 60 and so on, so the timing is uncertain.
Loss must be definite and measurable
The insurer should be able to measure the loss in definite terms of cause, time, place and amount. There should be no ambiguity as to whether loss has occurred or not. In other words, there should not be any doubt on whether the payment is due under the policy or not.
The cause and time of death can be readily determined in most cases, and if the person is insured, the face amount of the life insurance policy is the amount paid. The losses are fairly predictable and can be measured in monetary terms.
The loss must not be catastrophic
All the insured persons in a homogeneous group should not be exposed to an adverse event and incur losses at the same time.
You must have understood by now that pooling is the essence of insurance. If most or all of the insured persons in a homogeneous group simultaneously incur a loss, then the pooling technique breaks down and becomes unworkable and unviable. Life insurance technique is a viable arrangement as long as losses of few persons are spread over the entire group.
Insurers generally avoid all catastrophic losses. In reality, however, this is impossible, because catastrophic losses periodically result from floods, hurricanes, earthquakes, and other natural disasters. Many life insurance companies protect themselves against catastrophic losses by taking out sufficient reinsurance.
Premium should be economically feasible
The insured persons must be able to pay the premium. The total premium paid during the entire term of the policy must be substantially less than the sum assured (face value) amount of the policy. As the life insurance pool is structured to be sufficiently large, the price charged by the insurer for buying the risk is generally low.
You have seen in the above discussion five criteria which should exist for a risk to be insurable.