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In Part I of this book, we discussed the nature of risk and risk management. We defined risk, measured it, attempted to feel its impact, and learned about risk management tools. We statistically measured risk using the standard deviation and coefficient of variance, for example. We are going to emphasize the fact that risk decreases as the number of exposures increases as the most important foundation of insurance. This is called the law of large numbers. This law is critical to understanding the nature of risk and how it is managed. Once there are large numbers of accidental exposures, the next questions are (1) How does insurance work? and (2) What is insurable risk? This chapter responds to these questions and elaborates on insuring institutions.
The transfer of risk to insurers reduces the level of risk to society as a whole. In the transfer of risk to insurers, the risk of loss or no loss that we face changes. As we learned in Chapter 3 "Risk Attitudes: Expected Utility Theory and Demand for Hedging", we pay premiums to get the security of no loss. When we transfer the risk, insurers take on some risk. To them, however, the risk is much lower; it is the risk of missing the loss prediction. The insurer’s risk is the standard deviation we calculated in Chapter 2 "Risk Measurement and Metrics". The larger the number of exposures, the lower the risk of missing the prediction of future losses. Thus, the transfer of risk to insurers also lowers the risk to society as a whole through the law of large numbers. Even further, insurance is one of the tools that maintains our wealth and keeps the value of firms intact. As we elaborated in Chapter 5 "The Evolution of Risk Management: Enterprise Risk Management", people and firms work to maximize value. One essential element in maximizing the value of our assets is preservation and sustainability. If purchased from a credible and well-rated insurance company, insurance guarantees the preservation of assets and economic value. In this chapter, we will cover the following: