What is Amount at Risk?
The amount at risk is essential for insurance and banking. It means two different but related things, depending on whether you discuss insurance policies or loans.
Amount at Risk in Insurance
When we’re talking about insurance, the amount at risk means whichever of these two numbers is smaller:
- The insurance company promised to pay the maximum on that policy if something terrible happened. This maximum payment amount is called the “policy cap.”
- The most significant amount of money the insurance company thinks the person or business they’re insuring (called the “insured”) could lose if that bad thing happens to them. The insurance world calls this possible loss the “maximum probable loss.”
So, let’s say a business bought fire insurance in its office building. The policy says the maximum the insurer will ever have to pay out for a fire is $500,000. That’s the policy cap.
However, when the insurance company examines the office building, it decides that the worst fire that could realistically happen would only cause about $350,000 in damage. That’s the maximum probable loss.
In this example, the amount at risk is $350,000. It’s not the total $500,000 policy cap because, based on the insurer’s estimates, they don’t think they’d ever have to pay that whole amount.
Insurance companies calculate the amount at risk for every policy they sell. Then, they add up all those amounts at risk to get a big-picture view of how much money they could have to pay out to all their customers if a bunch of bad things happen all at once.
This big-picture total is necessary because insurance companies always need a certain amount to ensure they can afford to pay everyone they’ve promised. The amounts at risk of all their policies help them estimate how much backup money they need.
Amount at Risk for Loans
When banks make a loan, like a mortgage for a house or a car, they want to ensure they can get their money back even if the person who borrowed the money stops paying them back. The bank usually requires the borrower to use something valuable as collateral to lower their risk.
The bank can take and sell collateral if the borrower doesn’t pay them back. For mortgages, the collateral is usually the house itself. For car loans, it’s usually the car.
The amount at risk on a loan is the difference between:
- How much money does the borrower still owe the bank? This is called the loan’s “principal outstanding.”
- How much money would the bank think it could get by selling that collateral if it had to?
Suppose someone borrows $200,000 from the bank to buy a house. After a while, they’ve paid back some of the loans, so now they only owe $150,000. That $150,000 is the principal outstanding.
But let’s say housing prices have dropped since they bought the house. The bank estimates that if they had to take the house and sell it, they could only get about $120,000 for it in the current market.
In this case, the bank’s amount at risk is $30,000. That’s the $150,000 principal outstanding minus the $120,000 it thinks it could get by selling the house.
The bank risks losing that $30,000 if the borrower stops paying and can’t get all its money back by selling the collateral.
Why Amount at Risk Matters
Amount at risk is significant for insurance companies and banks because it helps them understand how much money they could lose if things go wrong.
For Insurance Companies
Insurance is all about managing risk. People and businesses pay insurers to take on some of their risks. The insurer promises to pay out money if certain bad things happen, like a house fire, a car crash, or a big lawsuit against a company.
In exchange, the person or business buying the insurance pays the insurer a regular fee called a premium. The insurer invests the premiums from all its customers so they can grow. They want that money to be big enough to cover all the payouts they might have to make.
But here’s the thing – insurers don’t just look at the maximum they could pay on each policy. They know the chances of having to pay out the absolute maximum on every single policy they’ve sold are small.
Instead, they use the amount at risk for each policy to get a more realistic estimate of their potential payouts. By adding up the amounts at risk across all their policies, insurers can figure out how much money they need to keep on hand to be ready for likely payouts.
This is a big deal because it means insurers don’t have to keep quite as much money sitting around doing nothing. They can invest more, which helps their business make more money. But they still hold enough on hand to be financially responsible and prepared.
Amount at risk is also essential for figuring out how much to charge for insurance premiums. Higher amounts at risk usually mean higher premiums.
For Banks
When a bank lends money, it takes on risk. There’s always a chance the borrower will not pay it back.
Banks usually require collateral to protect themselves. But they know that collateral isn’t a perfect safety net. The value of collateral can go down over time, as in our example of house prices dropping.
Banks use the amount at risk to calculate how much they could lose on each loan if the borrower defaults and the collateral isn’t worth as much as they thought.
Banks can gauge their overall risk level by monitoring the amounts at risk across all their loans. If they see the amounts at risk getting too high, they might make fewer loans or require borrowers to purchase more valuable collateral.
This is important for banks because if they have too many borrowers defaulting and can’t recover enough money by selling the collateral, the bank could fail. And that would be a disaster for everyone who has deposited their savings in the bank.
So, just like insurance companies, banks use the amount at risk to strike a balance between making money by lending and investing and being financially safe and responsible.
Key Takeaways
Amount at risk might seem like a complicated idea at first, but it’s just a way for insurers and banks to get a realistic picture of how much money they could lose in a worst-case scenario.
For insurers, it’s about estimating their potential payouts to ensure they have enough money to cover them. For banks, it’s about understanding how much they could lose if borrowers don’t repay their loans and the collateral isn’t valuable enough to cover the loss.
In both cases, the amount at risk is crucial for managing these businesses’ financial risks. It helps them balance making money and being financially responsible for keeping their promises to their customers.