Principles of Insurance (Part 1)

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Risk: an introduction

"Risk" is the chance of loss or the uncertainty of loss. There is a "possibility", for example, that your house might burn down, that your car might be stolen, that there could be an earthquake, etc. These are "risks" or uncertainties that could cause you to have a financial "loss".

Risk is the uncertainty. Risk is not the loss itself.

You could have a loss that does not have the element of uncertainty such as your car tires getting worn out or needing to replace the batteries in your portable CD player. You know that sooner or later your car tires are going to get worn down and will need to be replaced. You know that batteries have a limited life. These are particular kinds of expected events. These example "losses" do not have the element of uncertainty and therefore do not present a "risk" in terms of insurance.

Losses must have the element of uncertainty or suddenness that is referred to as "fortuitous". We tend to exclusively think of this word in its positive meaning, such as, "I just won the lottery. How fortuitous." Well, I suppose I would be a bit more enthusiastic about winning the lottery, but you get the idea. "Fortuitous" in insurance parlance describes something that happens unexpectedly, generally in a negative context - a context of loss.

Note that the government is sometimes willing to insure certain expected losses.

So how can you manage risk? There are five general ways to do so:
1. Avoidance
2. Control
3. Retention
4. Transfer
5. Law of Large Numbers

You can avoid risk by not doing something, control risk by doing something (that could result in loss) in a strategic way, or retain risk and bear the burden of loss on your own if you suffer the loss.

Transferring risk and managing risk through the Law of Large Numbers is where insurance comes in. Let's take a look at each of these two risk management methods in turn.

Transfer
Transferring risk is really what insurance is all about. An individual, business, or organization transfers the risk and responsibility for paying for any losses that might occur. This transference can be to an insurance company.

In exchange for the insurance company assuming the risk, it requires that you pay a "premium" based on the "possibility" (is it possible?) and "probability" (is it likely?) that a loss will actually occur.

Risk can also be transferred to another party by use of a contract. An example of this transference is a car leasing company that technically owns the car but requires the individual leasing the car to provide the insurance. The owner of the car is the leasing company (lessor) who transfers the requirement to "own" the risk (by insuring the car) to the person leasing the car (lessee).

Law Of Large Numbers
One of the basic concepts in insurance is the "Law of Large Numbers" utilized by insurance companies to reduce the uncertainty and increase the accuracy with which an insurance company can predict the number of losses as pertains to a risk sector (auto, homeowner, etc).

The Law Of Large Numbers is a mathematical principle that states: when the number of similar, independent (not subject to the same loss event) exposure units (such as cars or houses) increases, the relative accuracy of predications about future outcomes (such as losses) based on these exposure units also increases."

This principle enables insurance companies to improve the predictability of losses by pooling a large number of similar independent exposure units. For example, if I look at two cars, it's difficult to predict what will be the likelihood of them being in accidents. Those two particular cars might be on the road many, many years without an incident; one of the cars might be in a fender-bender; both cars might end up getting totaled. Who's to say? However, if I look at 10,000 cars instead of two cars, I can start to make some fairly reasonable predictions about what will happen within that particular pool of vehicles based on accident statistics. For example, X% of those cars will have fender-benders.

Types of risk
Essentially, there are two types of risk:
1. Pure risk
2. Speculative risk

Pure risk
A "pure risk" exists when there is a chance of loss but no chance of gain. Insurance is only concerned with this type of risk.

Speculative risk
A "speculative risk" exists when there is chance of gain as well as a chance of loss.

The classic example for this is a game of chance, such as poker. The gambler places a $l00 bet knowing that he or she could lose the $l00 or could gain if he or she wins the bet. Gambling is done with the goal of winning based on the odds of winning (gaining) or losing. Business risks are speculative as well. A businessperson operates a business with the expectation of gain while fully aware of the risk of loss.

Insurance does not deal with speculative risk. So even though there is business insurance, those policies insure the pure risk aspects of business; insurance is not available to cover the speculation of business success.

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Not only are policy forms, clauses, rules and court decisions constantly changing, but forms vary from company to company and state to state. This material is intended as a general guideline and might not apply to a specific situation. The authors, LunchTimeCE, Inc., CEfreedom, and Insurance Skills Center, and any organization for whom this course is administered will have neither liability nor responsibility to any person or entity with respect to any loss or damage alleged to be caused directly or indirectly as a result of information contained in this course.