Insurance companies carefully evaluate the potential risks they are willing to cover based on their economic feasibility. This assessment involves a thorough analysis of the costs associated with providing coverage and the likelihood of potential losses occurring. Insurers seek to strike a balance where the premiums collected from policyholders are sufficient to cover the costs of claims while ensuring a reasonable profit margin for the company.
Avoiding Small Losses and High Probability Risks:
Insurance companies generally avoid covering small losses because the administrative expenses involved in processing and paying such claims might exceed the actual amount of the loss. Insuring small losses might not be financially viable for the insurer, as the administrative overhead costs could outweigh the benefits for both the company and policyholders.
Similarly, insuring against risks with a high probability of occurrence might lead to a scenario where the insurer is likely to pay out claims frequently. In such cases, the insurer’s financial stability could be at risk, as the constant payout of claims might outweigh the premiums collected, resulting in financial losses for the company.
Example:
Consider an insurance company that offers coverage for minor electronic devices, such as smartphones and tablets, against accidental damage. While the risk of accidental damage is relatively high for these devices, the cost of providing coverage for each individual claim might be significantly lower than the administrative expenses incurred to process and settle the claims. Insuring such small losses might not be economically feasible for the insurer, as the company would end up spending more on claim processing than it collects in premiums.
Maintaining Financial Stability:
By focusing on economically feasible loss exposures, insurance companies ensure their long-term financial stability. They strategically select the risks they are willing to underwrite, considering factors like potential claim frequency and severity, administrative costs, and overall profitability. This prudent approach helps insurers maintain the necessary financial resources to meet their obligations to policyholders and continue providing coverage in the long run.
