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Insurance
 is 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 allows individuals, businesses and other entities to protect themselves against losses and financial hardship at a reasonably affordable premium.

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. Let's take the example of driving a car. (For more insight on the concept of risk).

  • Type of risk: Bodily injury, total loss of vehicle, having to fix your car
  • The effect: Spending time in the hospital, having to rent a car and having to make car payments for a car that no longer exists 
  • The costs: Can range from small to very large
  • Mitigating risk: Not driving at all (risk avoidance), becoming a safe driver (you still have to contend with other drivers), or transferring the risk to someone else (insurance) 

Let's explore this concept of risk management (or mitigation) principles a little deeper and look at how you may apply them. The basic risk management tools indicate that risks that could bring financial losses and whose severity cannot be reduced should be transferred. You should also consider the relationship between the cost of risk transfer and the value of transferring that risk.

  • Risk Control -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 (ie. to an insurance company), or you retain that risk either voluntarily (ie. 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. For example, a business owner may decide that while he is willing to assume the risk of a new venture, he may want to share the risk with other owners by incorporating his business.

So, back to our driving example. If you could get rid of the risk altogether, there would be no need for insurance. The only way this might happen in this case would be to avoid driving altogether. 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 (ie. 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. Do keep in mind that in some instances, you are required to purchase insurance (i.e. if operating a motor vehicle). For risks that are of low loss severity but high loss frequency, the most suitable method is either retention or reduction because the cost to transfer (or insure) the risk might be costly. In other words, some damages are so inexpensive that it's worth taking the risk of having to pay for them yourself, rather than forking extra money over to the insurance company each month.