Transferring Losses | General Insurance Concepts

Insurance is purchased to protect against the risk of economic loss due to dying too soon (life insurance), living too long (annuities), and becoming ill, injured, or disabled (health insurance).

Insurance is a social device designed to transfer the risk of economic loss to a common pool of funds contributed by many people sharing the same risk.

Life and health insurance policies are contractual agreements between the insurance company (the insurer) and the policy owner (the insured) designed to indemnify the insured of financial loss upon occurrence of a specified event (death, disability, accidental injury, illness), provided a stipulated consideration (the premium) has been met.

Insurance contracts are unilateral, in that, only one party to the contract makes an enforceable promise (the insurer). Insurance contracts are also aleatory, in that the outcome depends on chance and the consideration exchanged may not be equal.

Risk is commonly defined as an exposure to adversity or danger. In the insurance business, the risk is the possibility of financial loss. Risk is the basic issue that insurance deals with; it is 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 his/her original financial position. Insurance is not designed to provide a person with the opportunity of gain or profit.

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:

Avoid
Reduce
Retain
Share
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 examining one’s 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 his/her policy included a $500 deductible, he/she would be responsible for the initial $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 since the insured is assuming a portion 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, simply put, is to place 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; insurance companies, by definition, are the only organizations with the authority to assume someone’s risk of financial loss.

Lesson Summary

Insurance plays a crucial role in safeguarding individuals against various risks like dying too soon, living too long, or becoming ill or disabled. Key concepts in insurance are:

Risk in insurance involves the possibility of financial loss, with pure risk only entailing loss while speculative risk includes potential gain, making the latter uninsurable.
Risk management strategies include avoiding, reducing, retaining, sharing, and transferring risks, with insurance being a common risk transfer method.

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.