A client is deciding how to handle the financial risk that her premature death could leave her family without income. Purchasing a life insurance policy is an example of which risk management technique?
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
Life insurance is the classic example of risk transfer: the policyowner transfers the financial burden of the loss — the economic impact of premature death — to the insurer in exchange for premium payments. The insurer pools the transferred risks of many insureds and, through the law of large numbers, is able to predict losses and price coverage. Risk transfer does not make the loss impossible; it shifts the financial consequences of the loss to another party. This distinguishes it from avoidance (eliminating the activity), retention (bearing the loss yourself), and loss reduction (minimizing the severity of a loss that still occurs).
Why the other options are wrong
- B) Risk avoidance means refusing to engage in the risky activity entirely, for example never driving to avoid the chance of a car accident. Buying life insurance does not eliminate the risk of death, so it is not avoidance; the risk remains, only its financial burden moves.
- C) Risk retention means bearing the financial consequences of a loss yourself, often through savings or self-insurance. That is the opposite of what insurance does, because the insurer rather than the insured funds the loss when a covered event occurs.
- D) Loss reduction lowers the severity of a loss that occurs, such as installing smoke detectors or wearing seat belts. Life insurance does not reduce the loss itself; it shifts the financial impact of the loss to the insurer through the contract.
Memory hook
Life insurance = rent out your risk. Transfer the financial sting of death to the insurer's pooled pocket.