Managing Risks

Insurance is purchased to protect you against the risk of economic loss from:

• dying too soon (life insurance)
• living too long (annuities)
• becoming ill, injured, or disabled (health insurance)

Insurance is a social device that transfers the risk of economic loss to a common pool of funds. Many people who share the same type of risk contribute to this pool.

Life and health insurance policies are contractual agreements between the insurance company (the insurer) and the policy owner (the insured). These contracts pay benefits when a specified event occurs (death, disability, accidental injury, or illness), as long as the required consideration (the premium) has been paid. Some health coverages, such as medical expense insurance, indemnify the insured by reimbursing the actual loss. Life insurance does not: a life has no measurable dollar value, so a life policy is a valued contract that pays the amount stated in the policy.

Insurance contracts are unilateral, meaning only one party makes an enforceable promise (the insurer). Insurance contracts are also aleatory, meaning the outcome depends on chance and the value exchanged by each party may not be equal.

Risk is commonly defined as exposure to adversity or danger. In insurance, risk means the possibility of financial loss. Risk is the basic issue insurance addresses; it’s why insurance exists. There are two types of risk: pure and speculative.

Pure risk involves only the possibility of loss and can be managed through insurance. The purpose of insurance is to indemnify, or restore, the insured to their original financial position. Insurance is not designed to give someone an opportunity for gain or profit. This is the principle of indemnity. It states that an insured should not profit from an insurance claim, but instead should be restored to the same financial condition they were in before the loss - no better and no worse. This principle ensures insurance serves its true purpose: covering losses, not creating financial gain.

Speculative risk includes the possibility of gain. Gambling and investing in the stock market are good examples. You may lose money, but you may also come out ahead. Speculative risk is not insurable.

Risk management is how one deals with the possibility of financial loss. There are five ways to manage risk:

1. Avoid
2. Reduce
3. Retain
4. Share
5. Transfer

The first method is to avoid risk. For example, a person might avoid the risk of wrecking a car by not driving.

Risk may be reduced by identifying exposures and eliminating them. For example, a person reduces the risk of health problems by exercising and eating right.

A risk is retained when a person decides to assume financial responsibility for certain events. Examples of risk retention include self-insuring and deductibles. A deductible is common to most property insurance policies. It is the initial amount of a covered loss for which the insured is responsible. For example, if an insured suffered a $5,000 loss and the policy included a $500 deductible, the insured would be responsible for the first $500 and the policy would pay the remaining $4,500. A deductible is a common form of risk retention. It allows insurers to reduce the cost of coverage because the insured is assuming part of the risk.

A business owner taking on a partner is an example of risk sharing.

The final method of managing risk is to transfer the risk to another party. For many risks, the best way to transfer them is through insurance. Risk transfer means placing the burden of possible economic loss on someone else. When insurance is purchased, a large, uncertain loss is exchanged for a small, certain loss: the premium. Insurance companies exist for this basic purpose. By definition, insurance companies are the only organizations that have the authority to assume someone’s risk of financial loss.

Lesson Summary

Insurance helps protect against economic loss from dying too soon, living too long, or becoming ill, injured, or disabled. Key concepts in insurance are:

• Risk in insurance is the possibility of financial loss. Pure risk involves only loss, while speculative risk includes the possibility of gain, which makes speculative risk uninsurable.
• Risk management strategies include avoiding, reducing, retaining, sharing, and transferring risk. Insurance is a common method of risk transfer.

Chapter Vocabulary

Definitions

Aleatory

A contract in which the number of dollars to be given up by each party is not equal. Insurance contracts are aleatory because the policyholder pays a premium and may collect nothing from the insurer or may collect a great deal more than the amount of the premium if a loss occurs.

Indemnity, Principle of

A general legal principle related to insurance that holds that the individual recovering under an insurance policy should be restored to the approximate financial position he or she was in prior to the loss. A legal principle limiting compensation for damages to equivalence to the losses incurred.

Pure Risk

Circumstance including the possibility of loss or no loss but no possibility of gain.

Risk

Uncertainty concerning the possibility of loss by a peril for which insurance is pursued.

Risk Management

Management of the varied risks to which a business firm or association might be subject. It includes analyzing all exposures to gauge the likelihood of loss and choosing options to better manage or minimize loss.

Speculative Risk

Uncertainty as to whether a gain or loss will occur. An example would be a business enterprise where there is a chance that the business will make money or lose it. Speculative risks are not insurable.

Unilateral Contract

A contract, such as an insurance policy, in which only one party to the contract, the insurer, makes any enforceable promise. The insured does not make a promise but pays a premium, which constitutes the insured’s part of the consideration.