Economic basis of insurance: ’underwriting risk’ and ’timing risk’
Another aspect of the economic basis of insurance is the nature of the risk transferred. One commonly recognised distinction is between’ “underwriting risk’ (uncertainty about whether an event will occur) and ’timing risk’ (uncertainty about when an event will occur). Discussion of this is to be found in the Statement of Recommended Accounting Practice (SORP) on Accounting for Insurance Business issued by the Association of British Insurers (ABI) in 2005. For example, insurance risk is defined (paragraph 43) as:
“Uncertainty over the likelihood of an insured event occurring, the quantum of the claim, or the time when claims payments will fall due.”
A transfer of an insurance risk is defined (paragraph 74) as:
“A transfer of insurance risk, which may involve underwriting risk or timing risk or both, between the insured and insurer as a result of which, having regard to the commercial substance of the contract or contracts being evaluated, there are a number of reasonably possible outcomes some of which may present the insurer with the possibility of suffering a material loss.”
And in relation to reinsurance, paragraph 248 onwards refers to the importance of identifying the economic substance of the transaction:
“A key characteristic of reinsurance is the transfer and assumption of significant insurance risk…The insurance risks relating to a general insurance contract may consist of either or both of underwriting and timing risk.’’
A contract in which only timing risk (that is where there is uncertainty not about an event but about when claims will need to be met) is transferred, is arguably not a contract of insurance. Whole of life policies (where a benefit is paid on the certain event of death, whenever it occurs) are a type of contingency contract (GIM1040), and therefore insurance, but there are differing views as to whether an indemnity contract under which only timing risk is transferred can properly be described as a contract of insurance. This is discussed further in the section on financial insurance and reinsurance (GIM8180+).