Managing Potential Risks and Exposure
To understand what insurance is and how it operates, you must first be
under-risked. Danger means the same as a daily language as insurance.
The threat is the failure of chance or confusion. The risk of your house
being burglarized or being struck by a vehicle while crossing the street,
for example, reflects loss confusion. Both threats.
Note the risk is not the loss itself, but loss uncertainty. There are certain
unavoidable losses, such as when a rug eventually wears out after years
of use or a vehicle runs out of gas. Such losses are not threats because
they reflect loss certainty rather than uncertainty.
Another word that means almost the same is exposure. Exposure is a condition
or event that presents loss potential. For example, a home constructed
on a flood plain is vulnerable to flood damage.
We spend our whole life facing risk: crossing the street, swimming, buying
a new home, flying. These risks often result in minor losses we embrace
as a natural part of life, such as a stubbed toe or a missing pocket comb.
But threats may also result in significant financial losses, such as burning
a house or injuring an individual in a car accident. Such substantial
financial losses may have significant and far-reaching implications.
People have developed many different approaches to handle severe financial
loss risks. One method is to escape danger. For example, you can eliminate
the risk of auto-collision by never getting into a vehicle.
But minimizing all risks isn't realistic. Fortunately, not the only
way to handle risk. You can also somehow control danger. For example,
training employees in the safe use of welding equipment may curtail on-the-job
fire frequency. Risk management strategies under the heading of loss prevention
that trim loss frequency. Or, installing a sprinkler device in a factory
will not eliminate a fire, but it will limit the magnitude of any fire
that happens. Risk management strategies that determine the severity of
loss fall under the risk mitigation heading.
Often people retain a risk. That's, if any damage happens, they'll
pay for it. Often people maintain only a portion of risk — the part
that remains after other risk management strategies were employed. If
people know the risk and plan to keep it (or a bit of it), they do so
deliberately. If people are unaware of the danger, they can unconsciously
hold it and be shocked if a loss occurs.
The final risk control approach is to move it. This includes, though not
limited to, insurance. For example, a harmless hold agreement can transfer
liability from an owner to a tenant or subcontractor. (A hold harmless
agreement is a contractual arrangement where one party takes responsibility
for the situation and relieves the other party of responsibility.) But,
for certain risks, the only option is via insurance. We'll concentrate
on this way of managing the loss possibility in the rest of this unit.
Basics of Insurance
You found that moving it is one way to handle risk. That's what insurance
does. Insurance seeks not to prevent or eliminate risk but to pass a chance.
To see how it works, look at Middlefield's hypothetical town.
Middlefield has 200 homes worth $100,000. Typically one Middlefield home
burns down every year. If the homeowner has to pay for the building, the
owner will lose $100,000. However, if that loss were split among each
Middlefield homeowner, it would be just $500. Wouldn't you want to
pay $500, thinking you'd get $100,000 if your house burned down?
That's how insurance works. Instead of paying each other, people pay
insurance providers, thus transferring the liability and obligation to
pay for any damages in exchange for a premium. The insurance provider
accumulates these premiums to provide funds for loss claims. This means
that while people don't pay each other directly, they also share in
each other's loss expense.
So, a structured concept of insurance will be a contract or device to shift
liability from an individual, corporation, or entity to an insurance provider
that offers to pay for risks by accumulating premiums in return for a premium.
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