Pure Risks

by | Feb 8, 2017 | Risk

Although not an investment or speculative related risk, understanding a little about pure risks is worthwhile. If for no other reason than clearly distinguishing from an investment type risk.

Pure risks have only two possible outcomes. Either there is no change in status or there is a loss experienced. You cannot gain from a pure risk. Assuming, of course, you are not trying to defraud your insurer.

So what exactly is a pure risk?

Types of Pure Risks

Pure risks include personal, property, liability, and the failure of others.

Personal risks involve death, disability, and unemployment. An accident that leaves one disabled or dead, or being laid off from one’s job are examples of personal risks. In addition to health and life issues, personal risks may negatively impact current income streams, future earnings potential, and result in an increase of short and long term health care costs.

Property risks involve theft or damage to one’s property. A stolen car or fire to one’s house are examples of property risks. These risks may result in both direct and indirect losses. If your car is involved in an accident, you will need to repair the damage or replace the vehicle. That is the direct cost. But you will also need to pay for alternative transportation until your original vehicle is repaired or replaced. These other outlays are indirect costs (and losses to you).

Liability risks involve the legal system. If it is determined that property damage, personal injuries, or financial loss incurred by another party are the result of carelessness or negligence on your part, you may be liable for monetary damages or other penalties. If you own a business and someone slips on the icy sidewalk outside the front door, you may be liable for medical costs and lost earnings of the injured party. You may also be required to pay any other penalties that a shrewd plaintiff’s lawyer can obtain.

Failure of others risks are those where you suffer a financial loss when others fail to perform a service or meet an obligation to you. For example, you contract to move into new office space effective January 1. However, the provider has not completed renovations by that date. You must then find alternate office space until the renovations are done. Unless this is covered in the rental agreement, you will suffer financial loss by needing to pay for the other space.

Perils

In each case above, there must be both perils and hazards present.

A peril is simply a loss incurred by death, disability, illness, accident, lawsuit, dishonesty, carelessness, or negligence. Pure risks exist because of perils.

Hazards

A hazard is something that increases the probability (i.e. the chance or likelihood) of a peril occurring. It may also affect the severity of the loss.

Hazards may be physical, moral, or morale.

A physical hazard is a physical condition that increases the likelihood of a loss (peril) arising. Smoking in bed (hazard) increases the risk of a house fire (peril).

A moral hazard results from human traits such as dishonesty. Allowing staff access to the cash register (hazard) may increase the probability of employee theft (peril).

A morale, as opposed to moral, hazard is slightly more abstract. It involves inaction or indifference on the part of an individual. Ironically, insurance is a major contributor to morale hazards. For example, you live in an area of the city that experiences a high level of car thefts. Without auto insurance you would likely take several steps to secure your car at night. Tire locks, clubs for the steering wheels, expensive alarms and tracking systems. You would also ensure that nothing of value was left in the vehicle. But once you have auto insurance, the level of concern probably falls. You know that if there is a theft you will be covered by your insurer. That indifference, or lack of action, is the morale hazard.

Obviously, hazards may be interconnected. If you live in parts of Florida, there is a physical hazard of hurricanes during the year. That hazard increases the probability of property damage or personal injury (perils). Without insurance residents would take significant precautions to prevent damage. When I lived in the Cayman Islands, that included knocking coconuts from their trees before a hurricane. Once the wind starts blowing, those tasty treats become deadly cannonballs. Lacking insurance, there would also be a lot fewer people living in traditional hurricane zones.

But with insurance, residents take less precautions to safeguard their property. Beachfront homes are full and many residents remain during the storm. These are morale hazards that combine with the actual physical hazard.

After the hurricane, residents file insurance claims for damage. Maybe the roof that already needed new tile is suddenly damaged by the storm winds. Or the flooding destroyed a (previously broken) “mint condition” television. Filing a dishonest or fraudulent insurance claim is an example of a moral hazard.

Hopefully that gives you a quick, but adequate, overview of pure risks. Next up, a look at investment risks.

Introduction to Risk

by | Feb 3, 2017 | Risk

Let us move on now from discussions of financial advisors and into core investment topics.

The concepts of risk and return are key to understanding the investment process. If you can get your head around the relationship between risk and expected return across the different asset classes, you will become a much better investor.

Investors wish to maximize their returns while minimizing risk. Asset classes are compared on the basis of their risk and their risk-return expectations. Hedging activities are conducted to reduce risk while leveraging helps to increase risk.

Everything investors do relates to risk and return. But what is risk?

Risk

In general, risk is the probability of harm, loss, or injury occurring in the future. The damage may be emotional, physical, or financial. Fairly straightforward.

Where it begins to complicate is when you apply risk to a specific person. For each individual, risk is a different concept. One based on personality, financial situation, where they live, stage of life, and the unique experiences endured in life. Because of this, one’s perception of risk changes over time.

When young and carefree, there is no thought of death. But suddenly you get married, buy a home with a large mortgage, and have a child; your views probably change. What will happen to my family if I am suddenly gone? Life insurance becomes a very interesting topic.

Moving to the Caribbean from Western Canada, I developed a keen interest in hurricanes and tropical storms. And much less concern about icy roads and freezing pipes. Same person, but circumstances had changed in life. And so too my views of risks.

Just look at your own life. To some extent, how you view risk is likely different than friends and family. As well, over time your risk perspective and tolerance will adjust with new situations.

Risk may be categorized in many ways.

As you may hear or read about different terms for risk, let us quickly review the major classifications. That way, if someone mentions risk to you in a different context than the ones we discuss in detail, you will have some idea what they are referring to.

Fundamental Versus Particular Risks

You may see risks compared as fundamental or particular.

Fundamental risks are impersonal in nature and affect a large number of people simultaneously. War, hurricanes, and inflation are examples of fundamental risks.

Particular risks are the result of individual events and the results are much narrower. House fires, car theft, and murder are examples of particular risks.

Dynamic Versus Static Risks

Risks may also be contrasted as dynamic or static.

Dynamic risks arise from changes in the environment or economy that impact specific groups. When a dynamic risk occurs, for the individual directly impacted, there will be a loss incurred. However, for others not directly affected, or those nimble enough to quickly change their current situation, there may be opportunities for gain.

For example, as more people obtain their news electronically there has been a significant reduction in newspaper readership. This has caused many layoffs and bankruptcies. However, some internet news organizations have grown and prospered at the expense of old media.

Or consider that government regulations on fuel and carbon emissions have resulted in a significant restructuring of the auto industry. While this negatively affects those producing Hummers, makers of hybrid vehicles are benefiting.

Static risks, in contrast, are present even if there are no changes in the business environment. The risk is a constant regardless of the situation. Even when everything is going well there will be always be a percentage of people that suffer a loss.

For example, when the stock market is experiencing a lengthy bull market (i.e. broadly rising), some investors will still lose their capital. Or during periods of strong economic growth, there will continue to be individuals laid off from work. There is a risk of loss in good times, not simply the bad.

Pure Versus Speculative Risks

Finally, risk may be classified as either pure or speculative.

A pure risk may be either fundamental or particular. It may also be dynamic or static. However, a pure risk can only have two possible outcomes; a loss or no change in status. The potential loss from an earthquake, house fire, or losing one’s job are pure risks.

Unless you defraud your insurance company, you cannot prosper from a pure risk.

Speculative risks are different from pure risks in one important area. A third possible outcome exists. Like pure risks, speculative risks may have the potential for loss or no change in status. But there is also the possibility of incurring a gain.

Buying a common share of a public company is a speculative risk. When selling, you may lose some or all of your investment. You may also sell for the same price as you paid, thereby experiencing no change in status. Or you may make a profit on the sale.

Some people believe that, at times, dynamic risks can also be considered speculative risks. That is because they see individuals prospering from the impact of a specific dynamic risk. I understand the point but prefer to view them separately.

With a dynamic risk the potential gain is due to subsequent actions. The government introduces minimum fuel standards. Automakers that do not comply suffer a loss. Those that are agile enough to start a new business or adjust their current capabilities may prosper. But it is the subsequent actions that leads them to the opportunity, not the risk itself.

With a speculative risk, it is only the initial decision that results in a gain, loss, or no change. A speculative risk might be the business decision to develop and market an electric vehicle in anticipation of new laws affecting gas consumption. If the business decision is correct and new laws are enacted, the company may do well financially. If there are no laws imposed, consumers might stay with gas powered autos and the business may fail.

That business decision is the speculative risk. Investing is always a speculative risk.

We will focus on speculative risk because of its relationship to personal investing. And, if you do not mind, I will change the label from speculative risk to investment risk. This will save some potential confusion down the road when we look at speculation as a distinct component of the investment process itself.

Before we get into investment risk, we shall consider its counterpart, pure risk.