Understanding the Concept of Risk in Insurance

08 March 2022

According to the grand Indonesian Dictionary (KBBI), risk etymologically means a less pleasant, detrimental, harmful consequence of an act or action. Meanwhile in terminology, the word risk has many interpretations. Some interpret risk as objective doubts regarding the outcome of a particular situation. Risk is defined as uncertainty about economic losses. Risk is interpreted as the possibility of something unfortunate happening. And there are many other interpretations of risk terminology.

These interpretations are not wrong, but in relation to insurance, we need to take one relevant interpretation to be a benchmark in the insurance business. In that context, risk is defined as the uncertainty of loss.

Uncertainty is a situation that is always attached and faced by everyone in their daily activities. For example, will on the way to the office we survive to the destination?  Will the gadgets that we have not fall and break?  Will factory buildings that are equipped with a complete firefighting system really avoid the occurrence of fire events? And is the car we are driving not going to break down or have an accident?

But there are certain things that we can know for sure (with certainty) the situation or what will happen in the future. This is usually related to the law of cause and effect. For example, we know for sure that the decision to reduce the production machinery will cause the amount of production to fall. We know for sure that the increase in the number of employees will cause the company's expense to increase.  And we know for sure that stoves that are left to light up unattended can cause fire.

In general, the situation of uncertainty will remain attached to the human nature and all the activities that surround it, especially regarding things beyond the limits of human ability to be able to predict it. Even for things that can be predicted or forecast even though it still contains an element of uncertainty. For example, the Meteorology and Geophysics Agency (= BMKG in Indonesia) forecasts that heavy rain accompanied by strong winds in the Central Jakarta at 14.00 WIB. Although the weather forecast issued by such agency is very definite and detailed in terms of rain intensity, region, and time, but the it can actually happen as exactly as expected and can also miss the expected one.  Another example is that a soldier wearing a bulletproof vest is expected to survive the war. This prediction can be true and can be not true as a soldier who wears bulletproof vests can die during a war, not only just because of being shot but also because of another factor, namely heart attack for instance.  So, the situation of uncertainty is always there.

  1. Pure Risk and Speculative Risk
    A risk is considered a pure risk if in that risk there is a possibility of loss and the possibility of no loss (no loss) or in a state of break-even. An example is that the owner or operator of a ship can suffer losses if the ship hits another ship that is at anchor.  As a result, the operator must be responsible for the losses or damage suffered by the other ship.  However, if the ship does not experience a collision and arrives at the destination port as scheduled then the owner/operator will not experience losses or in a state of break-even.

    Furthermore, a risk is considered a speculative risk if the risk provides the possibility of loss and the possibility of no loss or in a state of break-even, as well as the possibility of profit (profit).  Take for example, a risk like this is a person who buys stocks or shares (as investors) at a value of Rp100,000 per share.

    As time goes by, the price of the purchased stocks or shares has three opportunities or possibilities, namely the opportunity to rise to >Rp100,000 per share, the opportunity to fall to <Rp100,000 per share, or the opportunity to stagnate or remain. If the stock price rises, then the investor profits, if the stock price drops then the investor loses, and if the stock or share price remains then the investor is in a state of break-even.

  2. Fundamental Risk and Specific Risk
    A fundamental risk is considered a risk that does not affect a particular person (impersonal), either in terms of its initial appearance or in terms of its consequences or impact. Losses arising from fundamental risk are usually not caused by a person and their effects or effects usually affect a large number of people or members of society. Examples of fundamental risk are including war, inflation, earthquakes, floods, tsunamis, and hurricanes.  These conditions occur not because of a person's attitude or actions and the impact on or felt by the crowd or society.

    Meanwhile, a particular risk is considered a risk that comes from individual events and their impact is felt locally. Examples of this risk among others are theft of property, damage to personal property due to an accident, explosive steam boilers, fires, and accidents.  This means that this particular risk is really specifically triggered by special factors and felt specifically by the victim or sufferer.

    As for the cause of loss, there are two terms commonly used in insurance, namely peril and hazard.

    Peril is defined as the cause of the loss. In a general insurance policy known as named-peril policy is a general insurance policy that lists one by one the dangers that have the potential to befall the property of the policyholder.  That is, the insurer will only be liable for a loss that befalls the property if the cause of the loss is a peril, or danger, listed in the policy.

    Meanwhile, hazard is a condition that can affect the occurrence or frequency of losses after the severity of that loss (severity of losses) if it occurs.   For example, the act of settling gasoline in a building in general will not cause a loss to the building, but gasoline can facilitate the occurrence of fires in the building and make the losses caused by the fire become more severe than average. In this case, the storage of gasoline in a building is a hazard, while fire as peril or the cause of the loss.

    Hazard itself has two characteristics, namely physical hazards and moral hazards (= are or related to the moral aspects of a person). Storage of gasoline in a building is a deliberate intention which is potential to cause fire or loss in the building and this is one example of physical hazards.

    Hence, the storage of gasoline in a building with deliberate intention of causing fire/loss to the building; especially with the intention to seek financial benefits from the loss to get a replacement from the insurer is obviously a moral hazard.

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