How does insurance act as a risk management strategy?

Insurance acts as a risk management strategy primarily by transferring financial risk to an insurance company. When an individual or organization purchases insurance, they pay a premium to the insurer in exchange for coverage against specific risks, such as property damage, liability, or health-related costs. This process allows the insured party to shift the financial burden associated with potential losses away from themselves and onto the insurer.

In essence, instead of facing the full financial impact of a loss — which could be devastating — the insured can rely on the insurance company to cover certain costs up to the policy limits. This transfer of risk helps individuals and businesses manage and mitigate the financial implications of unforeseen events, enabling them to plan and allocate resources more effectively without being overwhelmed by the risk of loss.

The other options do not accurately reflect the role of insurance in risk management. Increasing potential liabilities does not align with the protective function of insurance. Minimizing operational costs may happen indirectly as a result of better risk management but is not the primary function of insurance. Lastly, while insurance can significantly reduce the financial impact of risks, it does not eliminate all risks entirely; there will always be residual risk that cannot be insured.