Risk accompanies you at all times and is associated with whatever you do. Two types of risk can be distinguished: a speculative and a pure one. The first one is a result of what you do in the hope of making gains, although you can sustain losses as well (e.g. when buying shares on the stock exchange). In these situations you are more or less aware of taking such risk.
There are also events that occur beyond your control or intention, which can result in losses only (e.g. car accident, fire); the risk is pure then. Not always can your personal efforts reduce such risk (e.g. careful driving, fire-fighting equipment in operational condition), and many times its consequences exceed existing savings. This is why the coverage offered by insurers is often used to ward off pure risks.
Insurance products are based on the mechanism of risk distribution and relate to events that may happen in the future. From the point of view of an individual, future is hardly predictable. It is hard to know whether next year your house will be on fire. What an individual may find difficult to foresee can be predicted quite accurately for a larger community, however, that is, e.g. how many houses will burn in Poland annually.
With such knowledge available, you can predict how much money may be needed in case of these adverse occurrences happening. If this money is distributed among all (or a large proportion of) community members, then the burden will be relatively small as compared to potential losses an individual may experience, and one can be sure that none of the community members suffers financially (except for the cost of a premium) in case of a house fire. Such a community is called a risk community, and the above way in which negative consequences are financed – insurance.
It should be noted and stressed that the insurance premium depends on the risk, and the risk depends on the probability and amount of a potential loss. The insured who is able to reduce the probability or amount of losses can expect a lower premium. This relationship also causes that the higher the insurance sum, the higher the risk, and consequently the premium. Premium individualisation prevents anti-selection, which can occur with averaged premiums. Anti-selection exists when individuals with risk lower than average resign from coverage because they find it not worth paying for, whereas those whose risk is higher stay insured. This causes that the incidence of losses becomes higher for a risk community than for the whole population and the premium has to be increased. Even with a premium increased, it can still turn out that individuals with risk lower than average resign from coverage because they find it not worth paying for, whereas those whose risk is higher stay insured.
The premium is largely dependent on the degree and nature of risk to be insured. However, the existing incidence and extent of losses are not the only criteria for calculating the premium amount. Risk features that can affect the accuracy of how potential insurance benefits are assessed may be equally important. The insurance company runs a risk that the actual loss ratio, a relation of benefit payments to premiums received, will be higher than assumed at the time of determining the amount of insurance premiums. It is important, therefore, to make risk predictable, so that an insurance company could assess the incidence and extent of losses quite accurately using historical data.