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Overview of Risk and Insurance

In many risky situations, the possible outcomes can be classified either as losses or gains. People normally consider the downside possibility of losses to be risk, not the upside potential for a gain. There are situations in which there is no obvious downside or upside Risk aversion is a characteristic of an individual’s preferences in risk-taking situations. It is a measure of willingness to pay to reduce one’s exposure to risk. The process of formulating the benefit-cost trade offs of risk reduction and deciding on the course of action to take (including the decision to take no action at all) is called risk management All decisions made with respect to uncertainty must be made before that uncertainty is resolved. What matters is that the decision is the best one could make based on available information

Uncertainty

Uncertainty exists whenever one does not know for sure what will occur in the future.

Exposure

A situation or condition of having no protection from something harmful where it might affect you.

Risk

Risk is uncertainty that matters because it affects people’s welfare.

Risk Management Process

  • Risk identification: the process of anticipating potential hazards and their characteristics
  • Risk assessment: the process of analysing and evaluating the potential impacts of the hazards and risk factors identified. The quantification of the costs associated with the risks that have been identified.
  • Selection of risk management techniques : the process of choosing the most appropriate method of handling the potential hazard based on available information
  • Implementation: the process of putting the selected risk management technique or plan into effect
  • Review: the assessment of effectiveness of the risk management techniques with the intention of instituting change if necessary.

Risk Management Techniques

  • Risk avoidance: A conscious decision not to be exposed to a particular risk
  • Loss prevention and control: actions taken to reduce the likelihood or severity of losses. Action could be prior to, concurrent with, or after loss occurs
  • Risk retention: absorbing the risk and covering losses out of one’s resources
  • Risk transfer: transferring the risk to others
  • Hedging: Action taken to reduce exposure also causes the giving up of the possibility of a gain
  • Insuring: Paying a premium to avoid losses. Substituting a sure loss for the possibility of a larger loss if you do not insure
  • Diversifying: Holding similar amounts of many risky assets instead of concentrating.

Basic Features of Insurance

  • Exclusion: Losses that might seem to meet the conditions for coverage under the insurance contract but are specifically excluded. For example, life insurance policies pay benefits if the insured party dies, but such policies typically exclude payment of death benefits if the insured person takes his or her own life
  • Deductible: An amount of money that the insured party must pay out of his resources before receiving any compensation from the insurer.
  • Copayments: Meaning that an insured party must cover a fraction of the loss. Similar to deductibles. Difference is in the way the partial payment is computed and the incentives created for insured party to control losses
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