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Risk and Return in Insurance & Risk Management Strategies

Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define risk and return as it relates to the insurance industry, and you'll understand the correlation between the two. We'll also explore three risk management strategies and give examples of each.

What Is Risk?

Todd works for one of the largest insurance companies in the United States. Every year the company hires summer interns. This year, Todd's been chosen to facilitate a seminar on risk and return.

He starts by asking the interns, 'What's the definition of risk?' Someone says, risk is a chance of financial loss. 'Excellent,' Todd replies. And when we think about risk as it relates to returns, can we assume there is a direct or indirect correlation? Todd looks around the room at all the blank stares on the interns' faces. Then he says, 'Let's take a step back and define returns.'

Returns are the monies received from incurring a certain level of risk. In our industry, we'll call returns premiums. As a result, there's a direct correlation between risk and return. For a higher level of risk, we expect a high return or our customers to pay a higher premium.

In purchasing an insurance product, the customer has transferred the risk to an insurance company. This strategy is called risk transfer. There are also two other risk management strategies: risk assumption and avoidance.

Todd continues, 'Now for the rest of this seminar, we'll explore the risk and return concept as well as discuss the three risk management strategies.'

Risk and Return

Insurance companies are in business to accept risks -- risk that an automobile accident may occur, a house may burn down, or a business may flood. Insurance companies restore the property to its original state before the loss occurred.

However, insurance companies require a return, or premium. That premium is based on the risk. The higher the probability the loss will occur, the higher the premium.

Risk Management Strategies

Todd notices all of his interns are still alert and seemingly interested, so he continues. 'Now that you understand the concept of risk and return, let's review risk management strategies. We'll use a fictional character as an example; let's call him Craig.'

1. Risk Transfer

The risk transfer strategy allows consumers to transfer some or all of their risk to an insurance company. For example, Craig recently purchased a $150,000 home and knows the risk of ownership, some of which he can handle himself and others he cannot, such as a loss by fire. Since Craig does not have $150,000 in the bank to rebuild the house if it's destroyed by fire, he will insure the house, therefore, transferring the risk to the insurance company.

2. Risk Assumption

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