What is Actuarial Risk?

Jim B.

Actuarial risk is an insurance term that refers to the possibility that a damaging event may occur at a rate out of proportion with the probability of it occurring. The danger in this scenario is that an insurance business could be at risk if it occurs. Actuaries are employed by insurance agencies to determine actuarial risk. The job is meant to set up insurance premiums at a rate that will keep enough money coming in so that the insurers can settle any possible claims and remain profitable in the process.

An actuary calculates risk should a catastrophe occur, such as an earthquake.
An actuary calculates risk should a catastrophe occur, such as an earthquake.

Insurance companies are vulnerable to insolvency if actuarial risk is not properly calculated. For example, if multiple property-owners in a certain area get insurance to protect properties from a natural disaster like an earthquake, if the risk is not calculated properly the rates will not be enough to cover claims in the event of a major catastrophe. The insurer could set the premium levels relatively low for those people, determining that the likelihood of an earthquake in the area is remote. If, by chance, several earthquakes hit this area, the insurer would have to settle claims for each of those incidents. In this example, the miscalculation of risk could prove to be disastrous for insurer and customer alike if the insurer runs out of money.

Actuarial risk is used to determine life insurance rates.
Actuarial risk is used to determine life insurance rates.

Actuaries are trained to use several factors to determine the amount of risk for the people or things to be insured. They then set premium levels based on assessments. In addition, they also make sure there is enough money to pay damages and make necessary corrections to insurance rates as warranted.

There are other areas in which actuarial risk comes is a factor. Both businesses and individuals need to assess risk when managing finances. It comes into play in terms of stock market transactions, making large purchases like a home or a car, or when determining what type of life insurance policy might be best to provide security for a family in the long-term. All of these events have some type of risk attached, and knowing how to manage the level of risk and be prepared for the worst-case scenario can make the difference between financial success and failure.

The management of personal actuarial risk is achieved through many established techniques. Individuals should balance financial obligations by taking on several small risks rather than one or two big ones, thereby mitigating the effect of a negative outcome. In addition, it's wise to prepare for the consequences of a catastrophic event like a death in the family or a house fire, while also taking steps to reduce the possibility of an occurrence. Offsetting risk against another is another way to manage risk, especially in terms of finances, as it will lessen the impact of a loss with the prospect of a gain.

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