Insurance and Risk Management Essentials
Insurance: A Risk Management Strategy
Insurance is a risk management strategy that provides protection against loss.
- An insurer takes responsibility for the insured body.
- Policy: The terms of insurance.
- Premium: The cost of insurance.
- Deductible: Out-of-pocket expense against a claim.
- Claim: A loss covered by insurance.
- Policyholder: A person that owns the insurance.
Understanding Risk
- Risk: The probability of loss.
- Peril: The cause of loss.
- Hazard: Increases the probability of a loss.
- Pure Risk: Only the chance of loss (e.g., life insurance, car insurance, home insurance).
- Speculative Risk: Possibility of both a loss or a gain (e.g., gambling).
Insurance is typically available for pure risk, rarely for speculative risk.
Risk Management Strategies
- Risk Avoidance: The best way to deal with risk is to avoid engaging with it, but this is not practical most of the time.
- Risk Reduction: Lowering the probability of risk; far more practical than risk avoidance.
- Risk Assumption: Internalizing the risk, meaning you accept it and prepare to deal with it, potentially carrying the loss.
- Risk Shifting: Transferring the liability of the risk to someone else.
Insurance is a blend of risk assumption and risk shifting. Conventional insurance is essentially risk shifting, but it involves some risk assumption as it’s not free.
How Insurance Works
The cost is approximately P(x)*x + administrative costs, where P(x) is the probability of loss and x is the amount of loss.
Self-insurance can save money by eliminating administrative costs, but ensure you have enough funds set aside to cover potential losses. It’s not always feasible for large assets.
Human risk assessment is often inaccurate; we underestimate common occurrences and overestimate uncommon ones.
Key Considerations for Insurance
- What needs to be insured?
- What risks will you face?
- What are the insurance costs?
- What are the deductibles?
Deductibles: The initial amount of money that insurance will not cover.
Specific Types of Insurance
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Home Insurance:
- Covers damage to the structure.
- Covers property damage to items in the house (theft, flood, fire).
- Covers personal risk (being sued):
- Negligence: Failure to do what is right.
- Liability: Fault (legal responsibility costs).
- Vicarious Liability: Carrying responsibility for someone else’s actions (e.g., parents).
- Strict Liability: Responsibility for actions, whether intentional or unintentional.
- Insurance on replacement value: How much it would cost to replace. There’s a difference between replacement value and market value.
- Depreciation Value: The reduced value of an asset.
- May include umbrella policies that cover a range of catastrophes.
- Tenant Insurance: Protects the property of tenants living within a property. Most home insurance will cover a tenant’s property if the landlord is at fault.
- Two categories of insurance:
- All Risk: Everything is covered except specifically stated items.
- Named Perils: Only covers specific items that are listed; nothing else.
Insurance also considers risk reduction. Reducing P(x) can lower costs. Sometimes, insurance will have specific conditions, and not following them can void your insurance.
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Auto Insurance:
- Covers damage to the automobile itself (theft, damage).
- Covers liability.
- Covers possessions (limited).
- Legally required in every part of Canada.
- No-Fault Insurance: An individual collects their loss from their own insurer.
- Coverage for medical claims.
- In some jurisdictions, you are required to have uninsured motorist insurance:
- Insurance that covers costs if the other party doesn’t have insurance.
- Supplemental Coverage: Package policies.
- Insurance cost is based on:
- Make/model/year.
- Purpose/use.
- Geography.
- Driver history (in Saskatchewan, it’s a factor).
- Private insurance may also consider:
- Driver category.
- Reductions in insurance may be available for certain safety features.
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Health and Life Insurance:
- Life Insurance: Payment made to a beneficiary upon death (usually).
- Purpose:
- Cover the costs of death.
- Replace income/provide benefits.
- Cover debts.
- Premiums are based on:
- Age.
- History.
- Amount of coverage.
- Rule of 7: 70 percent of 7 years of income.
- Depending on needs, it may be less or more.