Insurance Principles and Risk Fundamentals
What insurance does
Insurance transfers pure risk - the chance of loss or no loss - from an individual to a pool. It cannot handle speculative risk (the chance of gain or loss), which is why investment and business-venture risk is generally uninsurable. Pooling works only when exposures are numerous, similar, independent, accidental, and measurable; the law of large numbers lets an insurer predict aggregate losses even though individual losses are unpredictable.
Risk management techniques
Avoidance, loss prevention and reduction, retention (deductibles, self-insurance), sharing (hold-harmless agreements), and transfer (insurance). Ranking by frequency and severity is the standard planning tool: high-frequency, high-severity risks are avoided; low-frequency, high-severity risks are transferred.
Contract principles to name
Insurable interest; indemnity; subrogation; utmost good faith (representations, warranties, concealment); adhesion; aleatory; unilateral; conditional. Hazards are physical (icy steps), moral (intent to profit - arson, inflated claims), and morale (carelessness - leaving keys in the car). Adverse selection is what underwriting exists to control.
Traps
Questions mix up when insurable interest must exist - at the time of loss for property, at application for life. Indemnity limits property and liability recovery but not life insurance, which pays the stated face amount. Actual cash value (replacement cost minus depreciation) is not replacement cost. Moral hazard is dishonesty; morale hazard is indifference.
Worked example: coinsurance penalty
A building with a $1,000,000 replacement value is insured for $600,000 under an 80% coinsurance clause (required limit $800,000). A $200,000 loss occurs and a $1,000 deductible applies. Recovery = ($600,000 ÷ $800,000) × $200,000 − $1,000 = $150,000 − $1,000 = $149,000. Rule of thumb: the insured is a coinsurer on the shortfall; carrying the required limit removes the penalty.