How Does Insurance Works?

Investopedia.com defines insurance as "a form of risk management in which the insured transfers the cost of potential loss to another entity in exchange for monetary compensation known as the premium."

Insurance works by pooling risk.  It simply means that a large group of people want to insure against a particular loss pay a small sum of money (premium) into what we will call the insurance bucket, or pool.  When a contributor to the pool suffers a loss there is enough money to compensate (indemnify) them.

Because the number of insured individuals is so large, insurance companies can use statistical analysis to project what their actual losses will be within the given class.  They know that not all insured individuals will suffer losses at the same time or at all.  This allows the insurance companies to operate profitably and at the same time pay for claims that may arise.  You pay for the probability of the loss and for the protection that you will be paid for losses in the event they occur.

Risks
Wikipedia defines risk as "the potential that a chosen action or activity will lead to a loss."  It is a probability or threat of a damage, injury, liability, loss, or other negative occurrence that is caused by external or internal vulnerabilities, and that may be neutralized through preemptive action.

Life is full of risks - some are preventable or can at least be minimized, some are avoidable and some are completely unforeseeable.  What's important to know about risk when thinking about insurance is the type of risk, the effect of that risk, the cost of the risk and what you can do to mitigate the risk.

Risk Control
Risk control is the process of monitoring and controlling and keeping track of the identified and the unidentified risks.  This process will hope to identify risks that are no longer possible and risks that are coming due, as well as any new risks that may become evident.

There are two ways that risks can be controlled.  You can avoid the risk altogether, or you can choose to reduce your risk.

Risk Financing
If you decide to retain your risk exposures, then you can either transfer that risk (i.e., to an insurance company), or you retain that risk either voluntarily (i.e., you identify and accept the risk) or involuntarily (you identify the risk, but no insurance is available).

Risk Sharing
Finally, you may also decide to share risk.  If you could get rid of the risk altogether, there would be no need for insurance.  Also, if the cost of the loss or the effect of the loss is reasonable to you, then you may not need insurance.

For risks that involve a high severity of loss and a low frequency of loss, then risk transference (i.e., insurance) is probably the most appropriate protection technique.  Insurance is appropriate if the loss will cause you or your loved ones a significant financial loss or inconvenience.  For risks that are of low loss severity but high frequency, the most suitable method is either retention or reduction because the cost to transfer (or insure) the risk might be costly.