Insurance as a Risk Management Tool

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INSURANCE AS A RISK MANAGEMENT TOOL

As we all know, insurance is an indispensable thing to manage different risks in our life and work. Without it, our life style, values, even our social structure will change into a completely different way. Insurance can be used as many things. In this essay, we will mainly discuss about insurance as a risk management tool.

With time going by, people and companies take more and more care of their own health and wealth. However, there are uncertainties everywhere. Then they try to protect themselves by managing risks. Insurance is a well-known and easy way to do this. About insurance, different people have different understanding. The official definition tells us that Insurance is a financial agreement in which an individual pays a fee (known as a premium) to transfer the financial consequences of his insured losses to a risk pool administered by an insurer. (Mark S. Dorfman, 2013, 7) However, from different points of view, we can understand insurance in different way. From economic, it’s a kind of financial arrangement to apportion the loss of accidents. From points of law, insurance is a contact behavior. From society, it’s a very important part of social economic guarantee system. From management, insurance is a tool and a method to manage risk.

In a classic insurance agreement, firstly the insurer assesses its customers how much they should pay. The insurance price is based on the insurer’s expected cost of insured losses. An insurance system redistributes the cost of losses by collecting a premium payment from every participant (insured person or organization) in the system. (Mark S. Dorfman, 2013, 81) If insurers want to earn money from their customs, they will promise to pay the insureds’ claims if the event or accident happens in covered loss. However, there will be only a small amount of participants that suffer from losses, and that means the insurer will earn the rest amount of money except the part paid for those who suffered. It also means the insurance system redistributes the cost from those who are unlucky and then amortize it to all customers who have paid premium.

Insurance is not the only way to manage risk. What’s more, it may be the last way that a risk manager would like to choose in risk management. In my opinion, insurance cannot stop the event or accident happening, and it just compensates money for those companies or individuals that suffered from bad things. This might be the reason why insurance is the last choice. There are many other different ways that can manage risk. When we compare those methods with insurance, we will see how insurance work in a more specific way and know the characteristics of insurance and also other methods.

Risk avoidance is to avoid possible risk that individuals or companies may face. This way can lower possibility of losses even to 0 percent. One man may consider about the possibility of a car accident and then he chooses to stay home rather than going out for business. As a result, he avoids the possible loss but loses opportunity to earn money by business. If he buy an accident insurance, he doesn’t have to choose one of them---He will get refund if there is an accident, and he will do the business, too. However, it’s only a few risks can be avoided. Some risks cannot be avoided at all when someone wants to run a normal company. So people always try some other ways to reduce their losses. Loss reduction is a useful method. People sometimes use duplication to reduce losses simply. They copy their core files or data. If anything happens, the duplication can be used directly. Also, some firms use diversification to reduce losses. All of these methods can be called loss or risk control. At the same time, we differ insurance from loss or risk control to risk transfer. Insurance is a kind of method that can transfer risk partly or completely into insurer by paying premium. Nevertheless, it’s not the only way to transfer risk. Hedging, contractual transfer, and limited liability are three other methods to transfer risk. There are some differences between them all. Insurance and hedging can be put together as a risk-bearing financial institution. They both transfer risks to the institution in exchange for a fee. Hedging is widely used in financial trade, and insurance is used in almost all ranges with risk. Those non-institutional contractual transfer agreement transfer risks simply into individuals or groups by contract. This way is similar to insurance that they both sign a contract. The contracts have force of law that make people obey what they have signed before. Insurance is a modality of risk transfer, also, is the most common way to transfer risk to other companies or individuals. The reason why it can be accepted by most of people is that insurance is scientific, it based on a large amount of data. Insurers use statistics, probability, and other scientific math methods to analyze how much should the premium be.

Differ from other techniques, insurance has a kind of “the milk of human kindness”, when people buy insurance, they help others in some way. When minority people get into trouble, he or she will use the amount of money from majority.

Insurance and risk control have a related connection. First of all, they are both dealing with risk. Risks exist, so people create risk control and buy insurance. However, insurance is not the only way to control risk. Risk control has a wider range than insurance to deal with risk, and insurance is a more specific way that concentrate on loss reduction after accidents happen. Secondly, insurance is the base of risk control. Before the concept of risk control becoming a system theory, people use insurance to manage their companies’ and their own risks. As a result, insurance provide some important experience to risk control. There’s no doubt that insurance have more functions than control risk, just like risk control has some other methods than insurance. They work together as interlaced rings and influence each other in their developments.

For enterprises, there are almost every kind of risks that can appear. They have many ways to control risk. What’s more, some large companies have their own risk management apartment to manage all the possible risks that they may face in other different apartments, for example, in accountant apartment, business accounting mistake or accounting information mistake can lead to a wrong decision, and this may cause an amount of losses. However, because insurance have some strict basic principle which makes companies get compensation for only part of their losses, it’s actually the last way to manage risk. Before risks do appear, risk manager can have some ways to avoid or transfer risks to other institutions or individuals. Traditional risk manager concentrate more on pure risk and catastrophic risk. Nowadays, risk management is more likely to be a unitive system. Risk managers use different risk management tools aiming at different kinds of risks. For pure risks as fire, production responsibility, employee’s equity, etc. For financial risks as foreign exchanges, production price and interest rate risk, hedging, contractual transfer can be good methods to manage risks.