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The use of contracts to reduce and redistribute risk. In an insurance contract, the insurer accepts a fixed payment, or premium, from the insured, and in return undertakes to make payments if certain events occur. In life insurance the event insured against is the death of the insured, or his or her survival to some agreed age. In insurance for fire and theft the event insured against is damage by fire or theft to the insured's property. In motor insurance the event insured against is loss by fire, theft, or damage to ‘third parties’, that is, anybody except the insured and the insurer. In health insurance the event insured against is medical expenses and/or loss of earnings through ill health. In every insurance contract the insured pays to achieve a reduction in risk. Without insurance there is a small chance of a large loss; with insurance there is a certain small loss, that is the premium, and possibly some further loss if the damage done by the event insured against exceeds the sum insured. The insurer makes the reverse exchange, accepting a new risk for the sake of the premium. Insurers are willing to take on risk in this way for two reasons. One is that they may be risk-neutral, or at least less risk-averse than the people they are insuring. The other factor which induces insurers to take on risks is that if they take on a number of risks of the same general type which are largely independent, the proportional dispersion of their returns will be smaller than the average of the individual risks they take on. Insurance thus both reduces overall risk, and transfers risk to those with a comparative advantage in risk-bearing. See also deposit insurance; health insurance; life insurance; third-party insurance.

Subjects: Economics.

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