Module 1: The Meaning of Insurance

Many businesses and families have concerns about the possible financial effects of an unforeseen event such as a fire or an auto accident. People and businesses use insurance to alleviate some of these concerns, comforted by the knowledge that insurance will pay for some or all of the cost if events like this occur. While that may sound like a good system, how does it actually work?

Insurance is a risk management technique that transfers the risk of financial consequences of loss exposures from a person or business to an insurer. The insurer reimburses the insured person or business for covered losses. It is able to do this by sharing losses among insureds and collecting a pool of premiums (the price of insurance coverage) from which to pay the losses.

You might be thinking, "But what does this really mean?" Now we're going to go over some of the key terms in detail: risk, transfer, and pooling.

What Is Risk?

The first component of the insurance mechanism is risk. Risk is uncertainty about outcomes, and it can be negative or positive. For example, by purchasing a home, you take on negative risk, such as the possibility of the house catching fire, and positive risk, such as the possibility of being able to sell the home for more than you paid for it. While risk management is concerned with both positive and negative risks, people and businesses purchase insurance to alleviate the uncertainty associated with negative financial consequences.

Individuals and families are concerned about the possible financial consequences associated with damage to their homes and autos as well as lawsuits or injuries that they may be liable for because of their homes, autos, and/or actions. Businesses are concerned about the financial consequences of injuries to customers and employees, damage to their buildings and other property, and loss of profit if their business is interrupted.