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Risk is defined as the potential for, or uncertainty of, loss. There are two types of risk: speculative risk and pure risk.
Speculative risk is a risk that presents the chance for both loss and gain. Speculative risks are not insurable. For example, investing in the stock market and gambling are speculative risks. Individuals can realize financial gains, or they can lose all of their money.
Pure risks present a potential for loss only. Pure risks do not have any possibility of gain. Only pure risks are insurable. For example, injuries, illnesses, and death represent pure risks because an individual can only suffer a loss in the form of missed work and medical bills or burden survivors through the untimely loss of life.
| Characteristic | Pure Risk | Speculative Risk |
|---|---|---|
| Definition | Possibility of loss only, no chance of gain | Involves a chance for both loss AND gain |
| Insurability | Insurable | Not insurable |
| Examples in Life and Health Insurance | Injuries, illnesses, disability, death | Investing in the stock market, gambling |
| Key Exam Point | If the only possible outcome is loss, it's a pure risk | If there's any possibility of gain, it's a speculative risk |
Most state exam questions about risk types focus on identifying whether a scenario represents a pure or speculative risk. When answering questions about risk types, first ask yourself: "Can this situation result in a gain?" If yes, it's speculative and not insurable. If no, it's pure risk and potentially insurable. Insurance companies only insure pure risks.
It's impossible to insure every type of risk. For a pure risk to be insurable, it must involve a chance of accidental, measurable, and definable loss. General elements of insurable risk include:
As will be described later in this course, insurers use various underwriting techniques to evaluate risks and assign risk classifications. Insurers place risk exposures into one of three risk classifications: standard risk, substandard risk, or preferred risk.
The process of analyzing exposures that create risk and designing programs to handle them is referred to as risk management. Risk management may be accomplished by:
The risk may be reduced or managed by purchasing an insurance contract, known as risk transfer. In addition to risk transfer, there are other ways to manage risk.
| Method | Description | Examples | Best Used When |
|---|---|---|---|
| Risk sharing | Spreads risk among multiple parties | Coinsurance in a major medical insurance policy | Multiple parties can share the risk. |
| Risk transfer | Transfers risk from one party to another via legal contract | Buying insurance, incorporation, hold-harmless clauses | Risk can be transferred. (Cost effective, large loss potential.) |
| Risk avoidance | Eliminating an activity or condition that exposes to loss | Not building in a flood zone, not skydiving | Risk is too high. (Loss potential severe, no other solution viable.) |
| Risk reduction | Deliberate actions to reduce likelihood or severity of loss | Safety systems, training, maintenance | Risk cannot be avoided. (Controls are cost effective, multiple exposures exist.) |
| Risk retention | Maintaining personal reserves to address costs of loss | Deductibles, self-insurance, no insurance | Losses are small. (Frequent losses, predictable losses.) |
Risk sharing spreads risk among multiple parties. Each party assumes a portion of the risks that are covered by the arrangement. Reciprocal insurance companies (e.g., USAA in San Antonio, Texas) — also referred to as inter-insurance exchanges — are one type of risk sharing arrangement. An example of risk-sharing is the use of coinsurance in a major medical insurance policy. If the coinsurance split is 80% / 20%, then the insurance company carries 80% of the risk, and the insured carries 20%. Often, this risk-sharing mechanism is used in conjunction with the risk retention mechanism that's referred to as a deductible.
Risk transfer features a legal contract that transfers risk from one party to another. In general, insurance contracts are risk transfer arrangements. They transfer the risk of loss defined in the policy to the insurer in exchange for a known fee or premium. Buying insurance is the best way to transfer risk. Additional examples include incorporation and hold-harmless clauses in contracts. Reinsurance is one method that insurers use to prevent a catastrophic loss. Reinsurance is defined as transferring risk from one insurer to one or more other insurers. Many insurers can minimize exposure to substantial loss by reinsuring risks.
Risk avoidance means that risk can be avoided by eliminating an activity or condition that exposes a person to a type of loss or specific perils. Avoidance is the most complete form of risk management. For example, a company decides not to build in a flood zone and completely eliminates the risk of flood loss.
Risk reduction is the process by which a person takes deliberate actions to reduce the likelihood or frequency of a loss, or the severity of a loss if it should occur. This is different from risk avoidance since the risk is not completely eliminated. For example, installing smoke alarms and a sprinkler system reduces the risk of death and will reduce the amount of property loss in a building fire.
Risk retention is a conscious strategy in which a person maintains a certain amount of reserves to address unexpected expenses that are caused by insurable losses. Some forms of risk retention are limited, such as the deductibles in a health insurance plan or personal automobile insurance. Some large companies that have highly predictable patterns of loss also self-insure. Choosing not to purchase insurance at all is also a form of risk retention. For example, a person with a $1,000 deductible on their automobile insurance policy retains $1,000 of any risk if their car is damaged in an accident.
It's essential to know that "self-insurance" is much different from "no insurance." The former is a planned strategy that's based on holding reserves and self-financing losses. The latter is simply a refusal to acknowledge the reality of risk and the possibility of financial loss.
One way to remember these risk-handling methods is to use the acronym STARR (Sharing, Transfer, Avoidance, Reduction, and Retention).
Another risk management tool available is loss prevention. Loss prevention involves taking actions to eliminate damage or loss. In fact, it's a method used to identify and analyze risk and to control losses. For example, constructing a building with masonry rather than wood, removing flammable materials from a premise, or de-icing an aircraft's wings before takeoff are loss-prevention steps.