What is insurable?

For a risk to be insurable, a number of prerequisites need to be in place:

The risk must be definable and financially measurable
Insurance provides financial compensation against a risk materialising or offers a benefit or service if that risk occurs. The risk must therefore be fully definable, in order to remove any dispute over whether the loss has occurred (and hence when a claim payment is due). It must also be possible to put a price on the cost of the loss, in order to determine the level of compensation required. For insurance against car theft, for example, determining when the event has occurred and how much compensation is due is relatively straightforward. For injuries suffered in an accident, the courts will often decide on the level of compensation. For life assurance, where the financial losses are less straightforward, the compensation is specified in advance.

The risk should be random and independent
It is not possible to insure against an event that will definitely occur, since it involves no uncertainty and therefore no transfer of risk takes place. The occurrence of the insured event should be unpredictable and happen purely by chance, or at least be outside the control of the beneficiary of the insurance, otherwise moral hazard could result (see p8). Definite events, such as damage caused by wear and tear or depreciation, and events that are caused voluntarily and intentionally by the insured or someone hired by the insured, usually cannot be insured.
Life assurance works within this principle as, although death is certain, its timing is unknown.

The insured must have an insurable interest
There must be a recognizable relationship between the insured and the risk. Typically, this “insurable interest” is established by ownership or direct relationship. For example, people have insurable interests in their own homes and vehicles, but ot in those of their neighbours.

The insurer must be able to calculate a fair premium for the risk
As explained on p5, the premium charged to the policyholder must make economic sense. On the one hand, the insurer must be able to charge a premium that is high enough to cover future claims on its pool of risks and its expenses while still making a profit. On the other hand, the amount charged to insure an individual or entity must be a sum that the insured is willing to pay and must be substantially below that of the covered amount or it would not make sense to purchase the cover. This balance is best struck in an open, competitive private insurance market.

The likelihood of the risk must be calculable
In order to calculate a fair premium, the insurer must be able to calculate the possibility of the risk. This involves calculating both the average severity and the average frequency of similar risks with some degree of accuracy. To do this requires analysis of a reasonably large claims history for the particular event, based on the insurer’s own experience, industry data or other sources.

There should be limited risk of catastrophically large losses
The financial impact of the loss should not be so large that the insurer could not hope to pay for the loss. For events that could result in significant losses, insurers can use techniques such as reinsurance (see p9) to reduce their exposure. This is typically the case for insurance for natural catastrophes or airlines.

Coverage is generally only for indemnity
The payment made following the occurrence of an insured event only indemnifies the policyholder for the loss actually incurred; the policyholder cannot profit from the claim as this could change their behaviour to make the loss more likely (see “moral hazard” on p8).

Not all risks are insurable. For a risk to be insured, it must have a number of specific characteristics.