Merritt Personal Lines Manual: Risk Management
Life is risky and insurance is only one way to deal with risk. There are five basic ways to deal with risk. These are:
- Avoidance - removing the possible cause of a loss
- Reduction - reducing the chance of loss with safety techniques
- Retention - keeping all or part of the financial risk of loss
- Transfer - such as buying insurance
- Sharing - pooling the risk with a variety of other people who share the same risk
In order for an insurance company to be able to accept premiums and pool money to pay for particular types of losses, the insurance company has to have a large enough number of similar risks. This is called the law of large numbers. This law makes it possible to statistically predict the probability of loss within the group and therefore how much premium to charge.
Not every type of loss is insurable. There are seven characteristics of an insurable risk are:
- Losses to be insured must be definable
- Losses must be accidental
- Losses must be large enough to cause a hardship to the insured
- Losses must not be catastrophic to many members of the group at the same time
- The insurance company must be able to determine a reasonable cost for the insurance
- The insurance company must be able to calculate the chance of loss
In addition, insurance can only pay money to people who have an insurable interest in the property lost. Insurable interest is any interest a person has in a possible subject of insurance so that person will suffer a real financial loss.
Also, an insurance company must guard against the tendency of poorer than average risks to buy and maintain insurance. Adverse selection occurs when insureds select only those coverages that are most likely to have losses.
