Our daily lives are full of risk of accident and financial loss. Insurance is just one way to handle economic risk in our world filled with uncertainty.
Avoid Risk – Don’t do the activity that creates risk in the first place. An example is having a friend drive you home after a party when you had too much to drink.
Retain Risk – Accept and plan for a potential risk that can be affordable. An example would be setting aside money in savings for a new car looking ahead for when the “old clunker” final stops running.
Transfer Risk – Shift the potential of loss from an uncertain risk to others. Buying collision coverage as part of your auto insurance package for your new car is an example of risk transfer.
What is Insurance?
Insurance – A contract binding a party to indemnify another against specified loss in exchange for premiums paid.
Insurance is about shifting the risk of an uncertain accidental loss. An insurance contract (insurance policy) defines the risk transfer including the triggering events and potential future loss to be covered. An insurance company offers the insurance policy in exchange for a periodic payment called the insurance premium. If the covered event occurs, then an insurance company will make a payment (called a claims settlement) based on the terms of the policy.
An insurance company groups many individual risks and accumulates the money paid for these insurance contracts. While an accident is a random event to an individual, the average rate of accident can be calculated for a large group. An insurance company can then determine how much premium needs to be collected from each individual policyholder to have sufficient funds for expected future claims plus the cost of operating the insurance company.
Insurance is at its best handling the risk of large accidental and infrequent losses. Insurance is a tool to spread this risk of large losses across a group. Few of us can afford replacing a house damaged in a fire or defend our business from a million dollar personal injury lawsuit. However, our insurance company has the resources for these potential claims because it has accumulated premium (called surplus) from many policyholders over many years.