The idea that insurance companies are 'afraid' of risk is a half-truth. The reality is that insurers avoid substandard risks or those that aren't considered insurable. Indeed, there are at least two sides to every story. An insurance company exists to provide a service (risk coverage) but remain profitable. It is a business - not a charity. However, an insurer doesn't deny accepting risks or have deductibles and exclusions on a whim. There are several plausible insurance-specific and business reasons for insurers to avoid certain risks.
1) Underwriting losses
Insurance companies would experience significantly higher underwriting losses if they were not averse from uninsurable risks or high risks. An underwriting loss occurs when an insurer pays out more money than received on a particular policy. So if you paid $4,000.00 for medical coverage and you get a claim paid for $30,000.00, your policy would be considered an underwriting loss. The aversion from high risk is to reduce the likelihood of losses, since these affect the stability of the company.
2) Anti-selection
The tendency for those with greater risks to seek insurance coverage as opposed to those facing less risk is broadly referred to as anti-selection. Insurers have to be on the alert for those who may have ulterior motives that are often undisclosed. Thus, the application process is even more rigorous when higher coverage levels are involved. Also, anti-selection is also a reason for insurance companies employing concepts like deductibles, insurance excess and exclusions to manage the risk.
3) Moral hazard
Moral hazard refers to the danger of dishonesty with an insurance transaction. Insurance companies may seem unwilling to accept certain risks if it is felt that there is some dishonesty or non-disclosure involved. It may seem as if the insurance contract states that the insurance company does not cover more than it actually covers. However, this is merely to reduce the moral hazard it faces through non-disclosure or misrepresentation.
4) Preventing speculation
One insurance principle is that no one must gain from insurance. Even with life insurance, there is supposed to be some degree of parity between the sum assured and the economic value of the insured. Insurance is an instrument of compensation. Therefore, insurers may be apt to deny a risk if they suspect that there is some degree of speculation or illegal wagering.
5) Lower premiums
For insurance to be affordable, the risks must be kept at a satisfactory standard. Some risks are just too high for an insurer to accept- even at adjusted premiums. If a terminally ill patient seeks $100,000.00 in life insurance, imagine what his premium may have to be for the insurer to not guarantee an underwriting loss! Aversion from undue risk by insurance companies helps to maintain lower premium levels.
6) Profitability
One should not fool oneself. Insurance companies are in the business to make a profit. Before you view this as confirmation that insurance is a rip-off, consider that most businesses exist to make a profit. However, insurance does this by being prudent while providing a necessary service for society. Being too liberal with risks will affect an insurer's profit margins significantly.
7) Duty to policy holders as a 'going concern'
Depositors could make a 'run' on financial institutions with swift, unexpected withdrawals that could leave an institution illiquid or insolvent. Too many underwriting losses can lead to the winding up of an insurer. An insurance company is a long-term business. Risk selection is the key to sustaining this type of business. Poor risk selection would lead to the winding up of an insurance company. At that juncture, policy holders would lose their money or the coverage that they paid for.
8) Adherence to sound insurance principles and policies
The apparent risk-averse nature of insurance companies is not ad hoc. Insurers don't randomly reject business. They have policies in place that are based on the characteristics of insurable risks and risk assessment methods.
Insurers must discriminate in order for the company to survive. It is easy to suggest that insurers are 'afraid' of risk, but they are there to undertake insurable risks. Naturally, insurers have an issue with substandard or risks or those that are too high for a premium to be affordable or practical. Insurance companies are in the business of risk, but they must be prudent and selective. It is this discretion (and the lethargy of the claims process of some insurers) that can unfairly create the notion that insurers are risk averse.
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