Risk is the possibility of damage, injury, or loss caused by external or internal events. There are two types of risk: pure and speculative.
Pure risk involves only the possibility of loss. Examples of Pure Risk
- Visiting a friend in the hospital—exposure to bacteria or viruses.
- Intramural sports—an activity that may result in injury.
- Owning real estate—potential for a casualty loss or liability claim.
Speculative risk involves the possibility of loss or gain, like the stock market or gambling. Some types of risk can be mitigated through insurance. Theoretical risk is not insurable, however.
Risk is also evaluated on an economic scale, comparing static and dynamic risk.
Static risk is the economic loss caused by factors other than a change in the economy (natural disasters). Dynamic risk results from the changing economy (changes in the business cycle). Emotional risks are not insurable.
Is Risk Insurable?
The loss produced by the risk should be reasonably predictable by the presence of a sufficiently large number of homogeneous exposure units.
- The loss must be definite and measurable.
- The loss must be fortuitous or accidental.
- The loss must not be catastrophic to the insurance company.
Risk, peril, and hazard are essential terms in insurance. In everyday use, these terms have almost the same meanings. In the insurance business, however, each word has a distinct and unique meaning.
Types of Risks
Two broad types of risks are:-
- Pure and Insurable Risks
- Speculative and Uninsurable Risks
Personal, property, and liability risks are pure or insurable risks. The insurance company will have to pay only if some event that the insurance covers happens. Pure risks are accidental and unintentional. Although no one can predict whether a pure risk will occur, it is possible to expect how much it will cost if it does.
- Personal risks involve loss of income or life due to illness, disability, old age, or unemployment.
- Property risks include losses to property caused by perils, such as fire or theft, and hazards.
- Liability risks involve losses caused by negligence that leads to injury or property damage. Negligence is the failure to take ordinary or reasonable care to prevent accidents from happening. If a homeowner does not clear the slippery item from the front steps of her house, for example, the homeowner creates a liability risk because visitors could fall on the slick thing.
Speculative risk is a risk that carries a chance of either loss or gain. Starting a small business that may or may not succeed is an example of theoretical risk. Speculative risks are not insurable.
Terms Associated with Risk
Risk is the chance of loss or injury. You face risks every day. For example, if you cross the street, there is some danger that a motor vehicle might hit you. If you own property, there is a risk that it could be lost, stolen, damaged, or destroyed.
In the insurance business, risk means that no one can predict trouble. This means an insurance company takes a chance every time it issues an insurance policy. As a result, insurance companies frequently refer to the insured person or property as a risk.
Peril is anything that may cause a loss. It is the reason that someone takes out insurance. People buy policies for protection against a wide range of perils, including fire, windstorms, explosions, robbery, and accidents.
Hazard is anything that increases the likelihood of loss through peril. For example, defective electrical wiring in a house is a hazard that increases the chance that a fire may start.
Peril and Hazard
Related to risk are peril and hazard. A peril is the cause of an economic loss. An economic loss is an event for which insurance is purchased. Insurance protects against a financial loss. Examples of risks include collision, fire, hurricane, and theft. A hazard is a condition that may create or increase the chance of an economic loss arising from a given peril.
A moral hazard is a potential for economic loss as the result of individual tendencies on the part of the insured. A moral hazard involves some prior knowledge or premeditation. These tendencies could lead to peril and create an economic loss. For example, Smoking cigarettes can lead to emphysema. Moral hazards are behaviors with little or no regard for consequences.
A morale hazard is an individual tendency that arises from attitude or state of mind. Often, it is a temporary lapse in judgment or careless attitude. An example of a morale hazard is road rage.
A physical hazard is a characteristic of an individual or property that increases the chance of an economic loss. An example of a physical hazard is building a house in a flood zone.
Risk management is an organized way of protecting yourself, your family, and your property. It helps reduce financial losses caused by destructive events. Risk management is a long-range planning process. Your risk-management needs may change at various points in your life. If you understand how to manage risks, you can provide better protection for yourself and your family.
Most people think of risk management as buying insurance. However, insurance is not the only way of dealing with risk.
You can avoid the risk of a traffic accident by not driving to work. A car manufacturer can avoid the risk of product failure by not introducing new cars. These are both examples of risk avoidance. They are ways to avoid risks, but they involve serious trade-offs. You might have to give up your job if you cannot get there by driving a car. The car manufacturer might lose business to competitors who take the risk of producing exciting new vehicles.
In some cases, though, risk avoidance is practical. For example, taking precautions in high-crime areas might avoid the risk of being robbed. Likewise, installing a security system in your car might prevent the risk of having it stolen.
You cannot avoid risks altogether. However, you can decrease the likelihood that they will cause you harm. For example, wearing a seat belt can reduce the risk of injury in a car accident. You can reduce the risk of developing lung cancer by not smoking. By installing fire extinguishers in your home, you can reduce the damage that could be fire could cause; you can lower your risk of illness by eating correctly and adequately regularly.
Risk assumption means taking on responsibility for the negative results of risk. It makes sense to assume the risk if you know that the possible loss will light all. It also makes sense when you have taken all the precautions to avoid or reduce the risk.
Self-insurance is another option for risk assumption. By setting up your special fund, perhaps from savings, you can cover the cost loss of costly insurance that does not eliminate risks. Still, it does provide a way of covering losses as an alternative to an insurance policy. Some people are self-insured because they cannot obtain insurance from an insurance company.
The most common method of dealing with risk is to shift it, which means to transfer it to an insurance company. In exchange for the fee you pay, the insurance company agrees to pay for your losses.
Most types of insurance policies include deductibles. Deductibles are a combination of risk assumption and risk shifting. A deductible is the set amount the policyholder must pay per loss on an insurance policy. For example, if a falling tree damages your car, you may have to pay initial Rs 20,000 toward the repairs. Your insurance company will spend the rest of the amount.
Conclusion: Insurance Provides an Efficient Risk Management Tool
Risk is the probability of a harmful event occurring that will result in a loss. Risk management is a process that involves identifying risks, assessing the risks, and mitigating the risks. Risk assessment involves determining the probability of the occurrence of the event and the magnitude of the impact if the event occurs. Risks can be managed through avoidance, reduction, assumption, and transference of risks. Transferring risks to a third party is usually done through insurance, where the insurance company agrees to pay the loss resulting from the occurrence of the risk in exchange for payment of a premium. While many risks are insurable, some are uninsurable because the risk is highly likely, inevitable, or the resulting loss cannot be quantified.