Risk Management

Ways to Deal with Risk

Life is risky, and insurance is not the only way to deal with risk. There are five basic ways to
deal with risk. Think of the acronym STARR:
• Sharing – pooling the risk with a variety of other people who share the same risk
• Transfer – such as buying insurance
• Avoidance – removing the possible cause of a loss
• Retention – keeping all or part of the financial risk of loss
• Reduction – reducing the chance of loss with safety techniques
In order for an insurance company to be able to accept premiums and pool money to pay for
particular types of losses, the insurance company has to have a large enough number of similar
risks. This is called the law of large numbers. This law makes it possible to statistically
predict the probability of loss within the group, and therefore how much premium to charge.
Ideally, insurable risk must meet certain criteria:

• Losses to be insured must be definable
• Losses must be accidental
• Losses must be large enough to cause a hardship to the insured
• There must be a homogeneous group of risks large enough to make losses predictable
(Law of large numbers)
• Losses must not be catastrophic to many members of the group at the same time
• The insurance company must be able to determine a reasonable cost for the insurance
• The insurance company must be able to calculate the chance of loss

In addition, insurance can only pay money to people who have an insurable interest in the
property lost. Insurable interest is any interest a person has in a possible subject of
insurance, such as a car or home, of such a nature that if that property is damaged or lost, that
person will suffer a real financial loss. For property and casualty insurance, the insurable interest
must exist at the time the loss occurs.
Also, an insurance company must guard against the tendency of poorer than average risks to buy
and maintain insurance. Adverse selection occurs when insured’s select only those coverage’s
that are most likely to have losses.