Managing Risks

Insurance is purchased to protect against the risk of economic loss from events such as property damage, legal liability, or other covered perils.

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

Property and casualty insurance policies are contracts 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 covered event occurs (such as fire, theft, or liability), as long as the required consideration (the premium) has been paid.

Insurance contracts are unilateral because only one party makes an enforceable promise: the insurer promises to pay benefits if a covered event occurs. They are also aleatory because 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 central 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 (or no loss) and can be managed through insurance. The purpose of insurance is to indemnify - to restore the insured to their original financial position. Insurance is not designed to create gain or profit.

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

Risk management is how you deal 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 taking steps to lessen them. For example, a person can reduce the risk of health problems by exercising and eating well.

A risk is retained when a person decides to assume financial responsibility for certain events. Common examples include self-insuring and deductibles.

A deductible is common in most property insurance policies. It is the initial amount of a covered loss that the insured must pay. For example, if an insured suffers a $5,000 loss and the policy has a $500 deductible, the insured pays the first $500 and the policy pays 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 taking responsibility for part of the risk.

Risk sharing means spreading the risk among multiple parties. For example, a business owner taking on a partner shares the financial risk of the business.

The final method is to transfer risk to another party. For many risks, the most practical way to transfer risk is through insurance. Risk transfer means placing the burden of possible economic loss on someone else. When you buy insurance, you exchange a large, uncertain loss for a small, certain loss: the premium.

Insurance companies exist for this purpose. By definition, they are the organizations authorized to assume someone else’s risk of financial loss.

Lesson Summary

Insurance helps protect against economic loss from events such as property damage and liability. Key concepts in insurance are:

• Risk in insurance is the possibility of financial loss. Pure risk involves only loss (or no loss) and is insurable, while speculative risk includes the possibility of gain and is not insurable.
• 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 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.