An important part of determining the right level of insurance that you should have is understanding risk. Risk, in terms of insurance, is uncertainty concerning the occurrence of a loss.

There is risk in all areas of your life: there are risks involved in your lifestyle, your career, your environment, and so on. You can manage risk in four ways: you can avoid risk, reduce risk, assume risk, or transfer risk.

• Avoid risk: You can avoid some risks, such as risks to your health, by taking care of yourself, eating well, and exercising. You can avoid some financial risks by avoiding high-risk occupations and diversifying your investments.
• Reduce risk: You can reduce some risks by adding fire extinguishers and burglar alarms to your home, adding airbags to your car, or getting regular medical checkups. By taking these precautions, you can reduce the potential damage of some risks.
• Assume risk: You can assume some types of risk through self-insurance. For example, I used to own a 1973 Ford Pinto. Instead of carrying full-coverage insurance, which would have allowed me to get the car fixed if it were in an accident, I carried only liability insurance. If I had been in an accident, I would have had to pay to have the car fixed myself (in other words, I assumed the risk of repair and collision costs). If the costs are not too high, you can assume some risks by assuming the potential for additional costs.
• Transfer risk: You can transfer risk to others by purchasing insurance. You pay premiums to transfer the risk to an insurance company. Buying insurance is the process of transferring financial responsibility for a specific risk—death, disability, liability, and so on—from yourself to an insurance company.

Once you understand how to manage risk, you can determine which risks you can avoid, reduce, or assume, and which risks you should transfer to an insurance company or other entity.