An entrepreneur constructs a highly experimental, prototype solar-powered facility. When applying for commercial property insurance to cover physical damage to the building, the insurer declines the coverage. The underwriter explains that because this is the only structure of its kind in existence, the insurance company has no historical claims data to rely on and cannot accurately predict the frequency or severity of potential future losses.
Based on the underwriter's explanation, why does this exposure fail to meet the criteria for an ideally insurable risk?
- It lacks a large number of homogeneous exposure units needed to make losses statistically predictable.Answer
- BIt represents a speculative financial venture rather than an accidental pure risk.
- CIt creates a morale hazard because the experimental design inherently increases the likelihood of a loss.
- DIt introduces a physical hazard that fundamentally alters the definition of the covered peril.
Answer
It lacks a large number of homogeneous exposure units needed to make losses statistically predictable.
For an insurance company to accept a risk, it must be able to use the Law of Large Numbers to predict future losses. This requires a large pool of similar (homogeneous) exposure units. Because the experimental facility is entirely unique, there is no historical data or group of similar risks to analyze, making the losses statistically unpredictable and therefore uninsurable.
Step-by-Step Solution
Key Concept
Elements of Insurable Risk: Statistical Predictability
Estimated Time:1m 15s