Risk exists whenever there is uncertainty about outcome. If you knew for certain that you would become a millionaire by purchasing the stock of a particular company, there would be no risk involved in investing. Likewise, if you knew that you would never be involved in an automobile accident, you would likely not purchase insurance..
Whenever you are faced with a risk, three possible things can happen:
- Positive outcome. If you purchase a lottery ticket and win, that is considered a gain.
- Negative outcome. You could purchase a lottery ticket and not win, therefore the money you spent purchasing the ticket is considered a loss.
- Neutral outcome. There’s no loss, but there’s no gain either.
Taking a risk means not knowing exactly what will happen. Facing risks is part of life, and it is the basic problem insurance addresses.
Risk, however, comes in two forms, and insurance only addresses one of them.
Pure risk exists whenever there are only two possible outcomes: loss or no loss. This is the type of risk insurance addresses.
Your home burns (loss) or it does not (no loss). Your car is damaged in an accident (loss) or it is not (no loss).
With speculative risk there is a third possible outcome – gain. When you purchase a company’s stock, the value of the stock could decline (loss), it could stay the same (no loss), or it could appreciate (gain). When a company comes up with a new product, it could be a flop (loss), it could break even (no loss), or it could be a huge success (gain).
Insurance does not deal with speculative risk, since the potential for gain or profit would be a violation of the general principles of insurable interest and indemnity. The purpose of insurance is to protect against loss. If there is no potential for a loss to occur or if there is potential for the person to profit or gain, insurance usually cannot be purchased.
Every individual and business needs to analyze their exposure to risk, decide if they are going to buy insurance and work to minimize the hazards associated with that risk. If you worked in insurance you could help businesses like St. Augustine Alligator Farm protect people using a zip line above crocodiles.
How Can You Manage Risks?
There are five methods a person can use to manage their risk of loss.
1. Avoidance: This risk management technique means that you eliminate the loss exposure or never acquire it in the first place. For example, if you fear having your car stolen, you might consider not owning a vehicle. If you already own the car, you could sell it.
2. Loss Control: For risks that cannot be avoided, loss control can reduce the number of losses (loss frequency) or the cost of losses that do occur (loss severity).— Examples: 1) Burglar alarms are a loss control device that reduces the number of losses that occur to property. A person intent on breaking into a home may see that the house has an alarm and decide not to commit the crime. 2) Seat belts and airbags in cars are designed to reduce the cost of a loss. While using them does not prevent auto accidents, these restraints generally result in less serious injuries.
3. Transfer to Others: Some risks can actually become the responsibility of someone else using a transfer such as contract or agreement. When you rent a car, the rental car company requires you to sign a contract in which you agree to pay for any damage to the vehicle. Rather than suffer the loss itself, the rental car company transfers that risk to you, the renter.
4. Retention: Retention means paying some or all of the losses that occur out of your own pocket. In the case of a small loss, like a cracked windshield, the car owner might l pay for the loss or sustain the damage without correcting the problem. The car owner may retain the loss (pay out of pocket) since it does not happen frequently and does not result in a large dollar amount of loss. It is also possible that the damage will not be repaired and the vehicle will be worth less money due to the cracked windshield. Either way, the burden of the loss falls on the vehicle owner.
5. Insurance: The last risk management method is insurance, or transfer of the cost of loss to an insurance company.