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.
