Risk and Insurance
Concept of risk
There is no single definition of risk. Risk has traditionally been defined as uncertainty concerning the occurrence of a loss. In other words, it is the chance or probability of the occurrence of unexpected events and outcomes, which cannot be correctly predicted and by which variability exists between expected and actual results or outcomes. Risk creates financial, physical, social and many other losses to people and society.
Elements of risk
- Uncertainty: This refers to a situation where the outcome is not certain or is unknown. When there is uncertainty there will be risk; the higher the uncertainty, the higher the risk, and vice versa. For example, if you invest in a corporate bond, there is uncertainty in receiving the principal and interest in due time because the company may go bankrupt.
- Probability of loss: When there is a probability of loss there will be risk. Risk creates financial, physical, social and many other losses to people and society.
- Effect of loss: Risk is the combination of the probability of an event happening and the effect of the loss. Loss depends on the quantity and frequency of the risk, the peril, the hazard, etc. So, the loss in every sector may not be the same even for a similar risk.
Types of risk
1. Pure risk and speculative risk
- Pure risk: Also known as absolute risk. A pure risk exists when there is a chance of loss but no chance of gain. In other words, a pure risk is a situation in which there is only the possibility of loss or no loss. The main types of pure risk are as follows:
- Personal risk: Risks that directly affect an individual. Premature death, insufficient income during retirement, poor health and unemployment are personal risks.
- Property risk: A person's property is exposed to property risk. Personal property can be damaged or destroyed due to fire, lightning, wind storm and other causes. For example, if we own a shop that is damaged by a fire, the physical damage to the shop is known as property risk.
- Liability risk: Under our legal system we can be held legally liable if we do something that causes bodily injury or property damage to someone else. A court of law may order us to pay substantial damages to the person we have injured. Such a risk is called liability risk.
- Speculative risk: A speculative risk is a situation in which either profit or loss is possible. A speculative risk exists when there is a chance of gain as well as a chance of loss. For example, betting on a horse race has the possibility of gain or loss. Another example: if a common stock price increases there will be profit, but if the price decreases there will be a loss.
Difference between pure risk and speculative risk
| Basis | Pure risk | Speculative risk |
|---|
| Meaning | A type of risk in which there is a possibility of loss or no loss. | A type of risk in which there is a possibility of gain as well as loss. |
| Insurability | Pure risks are insurable. | Speculative risks are not insurable. |
| Conceptual framework | The conceptual framework of risk can be applied to pure risk. | The conceptual framework of risk cannot be applied to speculative risk. |
| Desirability for society | In pure risk there is no benefit to society. | In speculative risk there may be a benefit to society. |
2. Fundamental risk and particular risk
- Fundamental risk: A risk that affects the entire economy or a large number of persons or groups within the economy. Rapid inflation, unemployment and war are some examples of fundamental risk, because a large number of individuals are affected by them. Fundamental risks are non-insurable.
- Particular risk: A risk that affects only individuals and not the entire community. For example, car thefts and bank robberies. Most particular risks are insurable.
3. Objective risk and subjective risk
- Objective risk: Defined as the relative variation between the expected loss and the actual loss. For example, suppose an insurance company has insured 10,000 houses over an extended period and 1% (100 houses) burn on average. It may not happen that exactly 100 houses burn each year; in some years only about 90 houses burn and in other years about 110 houses burn. Here the variation of 10 houses (10%) is the objective risk. The relative variation between the expected loss and the actual loss is known as objective risk.
- Subjective risk: Defined as uncertainty based on a person's mental condition or state of mind. For example, a customer who has been drinking heavily may attempt to drive home. The driver may be uncertain whether he will reach home safely without being arrested by the police for drunk driving. This mental uncertainty is called subjective risk.