Risk and Its Classification; Dealing with Risk

1. Risk and Its Classification; Dealing with Risk

Meaning of risk. In the study of insurance, risk means the possibility of an unfavourable or adverse outcome — that is, the chance that some uncertain future event will happen and cause a financial loss. Two elements must be present for risk to exist: there must be genuine uncertainty (we cannot be sure whether, or when, the event will occur), and the possible outcome must involve a loss rather than a certain gain. If an event is certain to happen and its timing is known, or if there is no possibility of loss at all, there is no risk in the insurance sense. Risk should not be confused with peril (the actual cause of a loss, such as fire, flood or theft) or with hazard (a condition that increases the chance or size of a loss, such as storing petrol carelessly near a flame).

Classification of risk. Risks are grouped in several ways, and a student should be able to explain each pair:

1. Pure risk versus speculative risk. A pure risk involves only two possibilities — loss or no loss — with no chance of gain (for example, the risk of a fire, an accident or death). A speculative risk involves three possibilities — loss, no change, or gain — and is deliberately taken in the hope of profit (for example, buying shares or starting a new business). This distinction matters enormously in insurance because, as a general rule, only pure risks are insurable — an insurer will not cover a risk the person took on purpose hoping to profit from it.
2. Fundamental risk versus particular risk. A fundamental risk affects a large group of people or society as a whole and arises from causes beyond any single person's control (for example, earthquakes, floods, war or widespread unemployment). A particular risk affects only one individual or a small number of people and arises from individual causes (for example, one person's house catching fire, or one car being stolen). Particular risks are the ordinary subject matter of most insurance; some fundamental risks (like large natural catastrophes) may need special arrangements or government support.
3. Financial risk versus non-financial risk. A financial risk is one whose outcome can be measured in money terms (loss of property, loss of income), and only such risks can be insured, because a claim must be settled in money. A non-financial risk is one whose outcome cannot be measured in money (for example, the risk of choosing the wrong career, or personal unhappiness), and is therefore not insurable.
4. Dynamic risk versus static risk. A dynamic risk arises from changes in the economy or society — changes in prices, tastes, technology or law — and can affect many people at once; it is harder to predict. A static risk arises even when the economy is unchanging, from natural causes or from the dishonesty of individuals (fire, theft, accident); because static risks are more regular and predictable, they are the kind insurance handles best.

Ways of dealing with (managing) risk. Once a risk has been identified, a person or business can respond to it in several ways:

1. Risk avoidance — deciding not to undertake the activity that carries the risk at all (for example, not investing in a business known to be very unsafe). This removes the risk entirely, but it also removes any benefit the activity might have brought, so it is not always practical.
2. Risk retention (self-assumption) — deciding to bear the risk oneself, either because the possible loss is small, or because cover is unavailable or too costly. A business may deliberately set aside a reserve fund to meet such retained losses.
3. Risk reduction / loss prevention and control — taking steps to reduce either the chance of a loss occurring or the size of the loss if it does occur (for example, installing fire extinguishers, fitting safety guards on machines, or storing goods carefully). This does not remove the risk but makes it smaller and more manageable.
4. Risk transfer — shifting the financial burden of the risk to someone else. Insurance is the most important and most systematic method of risk transfer: in return for a small, certain premium, the insured transfers the burden of an uncertain, possibly large loss to the insurer. …