When a client purchases a life insurance policy, the client is using which risk management technique with respect to the financial risk of premature death?
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
Insurance is the classic risk-transfer mechanism: the client pays a relatively small premium, and the insurer assumes the financial burden of a covered loss such as premature death. Risk transfer shifts the economic consequences of a loss from the individual to the insurer without eliminating the peril itself. The insured still faces the risk of dying; the contract simply moves the financial consequences of that risk to the insurer in exchange for the premium. This is why insurance is described as a transfer device rather than a device that removes or avoids risk. It also distinguishes insurance from retention, where the individual keeps the risk and pays losses out of personal funds, and from avoidance, where the activity creating the risk is simply not undertaken at all.
Why the other options are wrong
- Risk avoidance means not engaging in the loss-producing activity in the first place, such as refusing to fly or to operate heavy machinery; buying life insurance does not avoid the risk of death, which is unavoidable.
- Risk retention means keeping the risk and paying the losses out of pocket, as in self-insurance; a life insurance policyowner has instead shifted the financial burden to the insurer.
- Risk sharing spreads a loss among a group of participants who agree to share one another's losses, as in a voluntary mutual pool; insurance is best described as a transfer of risk to a professional risk-bearer, not sharing among equals.
Memory hook
Life insurance moves the risk off your back onto the insurer's books: that is transfer, not retention.