Everyone faces risk on a daily basis. This risk can be divided into two categories. Only one of which is insurable. Pure risk, where you only have the chance to stay as you are or have a loss, can be insured against. Speculative risk, which also offers the chance of gain, such as playing the lottery, can not.
There are five ways to handle risk. Not all of which will work for every situation.
Avoidance: A person can sometimes simply avoid the chance of loss. For instance, if you fear drowning because you are caught beneath a capsized canoe, don’t go canoing.
Retention: One can decide to keep the risk. You can keep only part of the risk, by buying an insurance policy with a deductible or copay. Or you can decide to self-insure certain risks, usually the smaller ones. Most people with pets do not carry pet insurance which would pay for some vet bills, etc. Instead, they choose to simply pay the bills as they come.
Sharing: This is not done as much as in the older days, but it is still an option for some. This is usually done with a formal risk sharing agreement. This is different from insurance as you still share a portion of the risk.
Reduction: While we can very seldom avoid risk altogether, we can do things to reduce that risk. We can reduce the chance of the loss happening, and also reduce the size of the loss if it does occur. A good example of this is the use of smoke detectors in your home.
Transfer: Finally we come to insurance. Insurance is a means to transfer our risk to an insurance company. We buy an insurance policy, and the risk of financial loss is now theirs, not ours. All we have to do is pay the premium. Once a proper insurance policy is purchased, if your car is damaged in an accident, the insurance company will pay to have it repaired…not you.
So how does an insurance company decide how much premium to charge each person? By the amount of risk that person has of sustaining a loss. They can estimate the risk of loss by looking at the hazards involved.
Hazards are what increase the chance of a loss occurring. They come in three forms:
1) Physical hazards are characteristics of an insured person or property. An example would be if your home’s electrical system is out of date. Your chance of fire would be greater than average. In auto insurance, an example would be the sports car. As the sporty models are built more for speed, they tend to be in more accidents than an average family-model car. Thus you will pay more in insurance for a Ford Mustang than you will for a Ford Taurus.
2) Moral hazards are an individual’s activities which can increase risk. If you have a tendency to speed, expect to pay more for car insurance. And yes, the insurance company does pay attention to your driving record, not just your history of accidents.
3) Morale hazards are harder to define. They exist when a person quits taking the proper precautions to avoid a loss, knowing that an insurance company will foot the bill. Past claims records can give an insurance company a clue here.
Once insurance companies have taken a look at your chance of loss, they put you in a group of insureds with similar loss exposure. This is using the Law of Large Numbers. The principle behind this law is that the larger the group of people with like risks, the more accurately they can predict the losses and charge premiums accordingly.
Insurance companies are able to insure your risks only because they are also insuring the risks of a great many others. Statistically, the Law of Large Numbers simply works.