Insurance is based on the value of loss and risk of loss. Insurance company and insurer exchange the risk in each other by establishing the contract . Insurer pays premium and insurance company takes the premium for the risk exchange.
An insurable risk is a risk that meets the ideal criteria for efficient insurance. The concept of insurable risk underlies nearly all insurance decisions. Eventuality for loss or damage that is (1) definable, (2) fortuitous, (3) similar to a large number of known exposures, and (4) pays a premium that is commensurate with the potential loss.
For an insurable risk there should be things that need to be true and actually happen.
• The risk cannot be catastrophic, or so large that no insurer could hope to pay for the loss so that the insurer must be able to charge a premium high enough to cover not only claims expenses, but also to cover the insurer's expenses.
• Definite and financially measurable nature of loss .
• The loss must be unintentional.
• Large number of exposures
• The loss should be random in nature, else the insured may engage in adverse selection
Insurance is not effective for risks that are not insurable risks. For example, risks that are too large cannot be insured, or the premiums would be so high as to make purchasing the insurance infeasible. Also, risks that are not measurable, if insured, will be difficult if not impossible for the insurer to quantify, and thus they cannot charge the correct premium. They will need to charge a conservatively high premium in order to mitigate the risk of paying too large a claim. The premium will thus be higher than ideal, and inefficient.
