Insurance is purchased to protect you against the risk of economic loss from:
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 policies are designed to indemnify the insured for financial loss when a specified event occurs (death, disability, accidental injury, or illness), as long as the required consideration (the premium) has been paid.
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:
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.
Insurance helps protect against economic loss from dying too soon, living too long, or becoming ill, injured, or disabled. Key concepts in insurance are:
Sign up for free to take 19 quiz questions on this topic