Economic basis of insurance: transfer and sharing of risk
Insurance as an economic device involves the transfer and sharing of risk. It is one of the ways in which risk can be managed. For example, risk may be avoided by not engaging in any form of hazardous enterprise at all. It may be retained, so that the person exposed to risk accepts responsibility for the potential financial loss, sometimes called self-insurance, that groups of companies may undertake using a captive (see GIM11000). It may be reduced, by limiting the magnitude of the loss or the likelihood of its occurrence, for example by installing a sprinkler system, or putting more secure locks on your doors and windows. It may be shared, for example by combining with others as members of a company.
Insurance is a way of sharing risk by transferring it to another person who is more willing to bear it. Such a transfer may be contractual, but not all contracts which transfer risk are contracts of insurance. Hedging instruments and guarantees are examples of non-insurance contracts which transfer risk, though the dividing line between insurance and other forms of risk transfer, and in particular derivatives, is sometimes a very fine one. The economic benefits of insurance are that the transfer and sharing of risk encourages economic activity, as the full risk does not fall on the entrepreneur.
Emmett J. Vaughan in Fundamentals of Risk and Insurance sums up the economic function and mathematical basis of insurance as follows:
‘From the social point of view, insurance is an economic device for reducing and eliminating risk through the process of combining a sufficient number of homogeneous exposures into a group in order to make the losses predictable for the group as a whole.’