6. Risk and Insurance

How can we reduce or eliminate risk ex ante? Financial markets offer different mechanisms that enable us to choose how much risk we want to bear and transfer the rest to an external party. Insurance is one such mechanism whereby the buyer of an insurance policy transfers some or all the risk to an insurer in exchange for regular payments commensurate with the risk involved and the insured loss.

Suppose, for example, that your house can be burglarized with some positive probability. You can transfer that risk to an insurance company by buying a home insurance. The insurer bears the risk in exchange for regular payments called premia. The premium that you pay on your insurance contract is the price of insurance. It is commensurate with the likelihood of your home being burglarized and the size of the loss. Notice that a risk transfer does not eradicate the risk. Your home can still get burglarized even if you have insurance. However, in that case, your insurance company will indemnify or compensate you depending on your loss and the contract agreement.

Risk transfer is one of the four major risk management strategies. The remaining three strategies are risk reduction, risk avoidance and risk acceptance. You can take an action to reduce a risk. For example, you can install a home security system to prevent your home from being burglarized. In some cases, it is possible to eliminate a risk by choosing an appropriate course of action. For example, investing in the stock market is risky. You can eradicate this risk by choosing not to invest. If you do not take any action to mitigate a risk, then you accept it and you will have to deal with its consequences when the time comes if the risk occurs. Your best course of action will depend on the context, the potential loss, and your preferences.