How do insurance companies manage risk?

What are ways to reduce insurable risk?

Risk management is a way to deal with the uncertainty surrounding potential losses (Risk). You face many types of risks in your daily life, even if you aren't aware of them. Most of the risks are small, but hazards such as automobile accidents, severe health conditions, or loss of life can have a financially devastating effect. So, how do we prevent the risk? Here are five basic strategies:

1. Sharing Risk.

Risk-pooling disperses risk to some people. Each individual pays a portion of the risk-based on how much they have put in. Suppose we agree to jointly buy a boat together with a purchase price of $10,000. We agree to pay a total of $4,000 and $6,000, respectively. Instead of paying premium insurance, we self-insure the boat. I will bear 40 percent of any loss that occurs, and you will take 60 percent of it, too.

2. Transferring risk.

Insurance is the most common way of transferring risk, but not the only way. When you buy insurance, you are paying someone else to take over your risk of something. You purchase insurance for your car or home. The insurance company assumes the risk of loss should the vehicle or home be damaged. Another risk transfer method, a hold-harmless agreement, may be used in some instances. A legally binding contract whereby one party agrees to hold the other party liable for any loss or damage that might arise throughout the contract. You agree to provide cleaning services to our office building. Still, we require you to sign a hold-harmless agreement indemnifying (securing against potential loss) us if you negligently cause death or injury. I have placed that risk in your hands.

3. Avoid Risks.

To stack things up, do not engage in an activity that carries potential risks. You can reduce the chance of an accident by never getting into a car. You won't be able to lose your retirement savings on investments with fixed rates. You are exposing yourself to less risk.

4. Reduce risk.

There is a lack of absolute safety, and the only way to control the risk level is by using risk reduction techniques. For example, without a fire suppression system, a fire in your home is likely to be more destructive than a fire with a fire suppression system. Or, you can lower your risk of dying in a sky diving accident by giving up skydiving and other spontaneous recreational activities.

5. Manage risk.

Financial responsibility is choosing to purchase insurance to cover all or part of a risk. It's on you if a loss does occur. An excellent example of this is our recent purchase of a boat. Both of us lost a certain amount equal to what we both put down when purchasing the boat. Another way of risk retention is when a policy has a deductible. You are automatically insured for a certain amount of the deductible.

What is risk management?

Risk management is a tool used by many insurance companies that reduces their risk level. A company purchases supplemental insurance from another insurance company to better manage its risks. The reinsurer guarantees the company against potential losses.

What is a reinsurer?

The insurance company's reinsurer agrees to reduce the number of losses paid by each party (either more than a certain amount or a percentage). The reinsurer gets their money from the primary insurer, and the insurer issues each policy.

As a fictional example, assume the large insurance company sells 1,000 policies, each with an average policy limit of $100,000.

$1 million is allocated to American RE (the reinsurer). In theory, the insurer could lose $1 billion. It would make more sense to distribute some of its risks to help mitigate their losses. In plain terms, a reinsurer is a company that insures another insurance company.

What are the principles of exoneration?

Indemnify means to repay, and indemnifying means to make liable. The indemnity principle stresses that an insurer will restore you to your pre-loss financial status: no profit, no loss. To indemnify means to make whole after loss, and also means to protect against loss. However, you are not entitled to any additional monetary compensation beyond your damages. There should be no benefit from your pain, just restoration.

Once your house is burnt down, the insurance company will provide you with a rebuilt house of the same quality. Out of spite, they will not build a larger home for you. We learned earlier that insurance companies are willing to insure pure risks or unharmed people. There is no gain or profit with pure risk.

If your house catches fire, the insurance company will not replace it with this specific product.