The Concept of Risk Management

Any introduction to insurance requires a clear understanding of the concept of risk. Many insurance professionals use the word risk to refer to an insured, a prospect for insurance or to the peril that is being insured. They will say that a particular person or property is a good risk or a bad risk, meaning that they have evaluated the underwriting characteristics of that person or property for a particular insurance policy. This usage differs from the strict insurance definition, which defines risk as the uncertainty regarding financial loss.

Accident vs. Arson
To understand this strict insurance definition of risk, consider what happens when an individual decides to burn down his or her own home. When gasoline is sprayed on the house and a torch is applied, the loss is certain. The event is purposeful in nature, and no uncertainty exists. Therefore, there is no risk (in insurance terms) of loss by fire. Conversely, when a house fire is started by faulty electrical circuitry or a lightning strike, the event is sudden and unexpected. Both the owner of the house and the financial institution that holds the mortgage on the house suffer a financial loss. The loss is uncertain and accidental; therefore, a risk exists and the loss is covered by insurance.

Speculative vs. Pure Risk
Risk, as defined by the insurance industry, can be of two kinds: speculative or pure. This distinction is important because, in general, only pure risks are insurable.

Speculative risk involves three possible outcomes: loss, no loss or profit. Investing in the stock market is an example of speculative risk. One might profit when the value of the stock rises, lose when it declines or break even if no change occurs.

Speculative risks are not insurable. Pure risk involves only two possible outcomes: loss or no loss, with no possibility of gain or profit. The risk associated with the chance of being robbed is an example of pure risk. No opportunity for gain exists if the robbery does not occur—only an opportunity for loss if it does. Only pure risks are insurable. A pure risk involves only the chance of loss, never the chance of a gain. Insurance protects against pure risk.

Speculative Risk
Speculative risks involve the chance of both loss and gain. Although betting at KejjrrPpint the racetrack or investing in the stock market are cited frequently as examples of $jjp speculative risk, individuals face many decisions every day that entail an element of this type of risk.

Some everyday examples of speculative risk decisions people face include
• remaining in current positions or looking for new jobs;
• remodeling or purchasing a larger home; and
• making only minimum installment payments or completely repaying current debt.

Because the possibility of loss or gain exists in all of the above decisions, the financial outcome is not insurable.

Loss and Exposure
Loss is defined for insurance purposes as unintended, unforeseen damage to property, or the amount the insurance company is obligated to pay because of personal injury. Everyday wear and tear on clothing represents destruction or decline in value; however, for insurance purposes, it is not a loss because it is the expected or intended consequence of wearing the clothes. Smoke damage to clothing caused by a fire in the house, in contrast, would be considered a loss that a person could obtain insurance to offset.

In the context of insurance, exposure is the possibility of a loss. It simply means the degree to which a person or property is vulnerable to risk or to the possibility of loss

Insurance
Insurance is a financial device for transferring or shifting risk from an individual or entity to a large group with the same risk. This is accomplished through a contract, the insurance policy, with an insurance company. Under this arrangement, the individual, along with other insureds, pays a sum to the insurance company. In turn, the insurance company agrees to pay an amount of money (reimbursement) to the individual, or on behalf of the individual, if the events described in the policy occur.

Insurance is used to indemnify, or restore, a policyholder to a preloss condition. The individual accepts a known cost, the premium, in exchange for payment of a large, uncertain financial loss. The insurance company combines, or pools, a large number of similar units (homes, autos, businesses, etc.) and thus can predict losses within these units.

The Law of Large Numbers
The mathematical principle of probability is called the law of large numbers. In insurance, a prediction must be made from past loss experience or statistical analysis of the number of losses to be expected within a group of exposures. The law of large numbers tells us that actual losses will be more accurate as the number of units of exposure increases.

This principle, known as the law of large numbers, states that as the number of observations of an event increase, the closer the predicted outcome will be to the actual outcome. Insurers know, within a very narrow margin, how many homes will be damaged each year by fire, although they do not know which homes will be damaged. This uncertainty introduces risk and makes it possible to insure homes against
fire loss.

Assume 1,000 homes in an area are each worth $50,000. Also assume that statistics show that five of these homes can be expected to burn this year. If each of 1,000 homeowners contributes his or her share ($250) of the expected $250,000 loss into a fund at the beginning of the year, an adequate insurance pool will exist to pay for the losses if they occur.

Similarly, an insurer issues policies insuring against the same type of risk to a large number of homeowners. The insurer knows how many homes may be destroyed by fire in a single year, but not which homes will suffer the loss.

Transfer (Other Than Insurance)
Some risks, or loss exposures, may be transferred to another person or entity. For example, a construction contract may transfer certain construction risks to a subcontractor, such as when an electrician agrees to hold a general contractor harmless for certain injuries that occur at the job site while the electrician performs his or her harmless duties.

Insurance is the most prominent device for transferring risk; however, there are noninsurance transfer options that are effective for some risks. Examples of noninsurance risk transfers include

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