Risk Management and Insurance
Risk management asks how organizations identify exposures and choose among avoidance, control, retention, and transfer.
Classifying risk
Pure risk offers only loss or no loss (fire, liability, employee injury) and is insurable; speculative risk includes the chance of gain (a new product, a stock purchase) and generally is not. Fundamental risks affect whole communities; particular risks affect individuals. Static risks exist apart from change; dynamic risks arise from economic or technological change.
The risk management process
Identify loss exposures, measure frequency and severity, choose techniques, implement, and monitor. Techniques: avoidance (eliminate the activity), loss prevention (reduce frequency), loss reduction (reduce severity), separation and duplication, retention (self-insure small, frequent losses), and transfer (insurance, leases, hold-harmless contracts). Insurance is most efficient for low-frequency, high-severity losses.
Insurance principles
Insurable risks are ideally accidental, measurable, predictable in the aggregate, and not catastrophic to the insurer. Indemnity restores the insured to pre-loss condition, never better, preventing profit from loss. Insurable interest must exist at purchase for property and at loss for life insurance. Utmost good faith requires disclosure, and misrepresentation can void coverage. Subrogation lets the insurer pursue the party at fault. Moral hazard is behavior changed by insurance; adverse selection draws high-risk buyers into a plan.
Policy mechanics
The premium reflects expected losses, expenses, and profit. Deductibles reduce small claims and lower premiums. Coinsurance requires insuring to a percentage of value or facing a penalty on partial losses. Common coverages include property, general liability, business interruption, workers' compensation (statutory, no-fault for employee injuries), commercial auto, key person life, and health.
Worked example
A building worth $500,000 carries an 80% coinsurance clause, so $400,000 of coverage is required. The owner insures only $300,000. A $100,000 loss is paid at $100,000 × ($300,000 ÷ $400,000) = $75,000, less any deductible. Insuring to value would have paid the full loss up to the limit.
Traps
Treating speculative risk as insurable; assuming indemnity permits replacement with something better; forgetting the coinsurance penalty applies only to partial losses; and confusing workers' compensation with general liability.