Insurance Shades: Concept of risk uncertainty concerning a potential loss
CONCEPT OF RISK
Meaning of Risk
There have been many attempts to define ‘risk’. Probably, to most of us,
‘risk’ contains a suggestion of loss or danger. We may therefore define it as
‘uncertainty concerning a potential loss’, a situation in which we are not sure
whether there will be loss of a certain kind, or how much will be lost. It is this
uncertainty and the undesirable element found with risk that underlie the wish and
need for insurance.
The potential loss that risk presents may be:
(a) financial: i.e. measurable in monetary terms (e.g. loss of a camera by theft);
(b) physical: death or personal injury (often having financial consequences for
the individual or his family); or
(c) emotional: feelings of grief and sorrow.
Only the first two types of risks are likely to be (commercially) insurable
risks. Also, from a wider perspective, not every risk will be seen in the negative
form we have just outlined (see 1.1.2a below).
Note: Without trying to complicate matters, we should also be aware that
insurance practitioners may use the word ‘risk’ with other meanings,
including:
1 the property or person at risk that they are insuring or considering
insuring; and
2 the peril (i.e. cause of loss) insured (so, some policies may insure on
an ‘all risks’ basis, meaning that any loss due to any cause is covered,
except where the cause is excluded from cover).
1.1.2 Classification of Risk
To simplify a complex subject, we may classify risk under two broad
headings (each having two categories) according to:
(a) its potential financial results; and
(b) its cause and effect.
1.1.2 Financial Results
Risks may be considered as being either Pure or Speculative:
(i) Pure Risks offer the potential of loss only (no gain), or, at best, no
change. Such risks include fire, accident and other undesirable
happenings.
(ii) Speculative Risks offer the potential of gain or loss. Such risks
include gambling, business ventures and entrepreneurial activities.
The majority of the risks which are insured by commercial insurers are pure
risks, and speculative risks are not normally insurable. The reason for this is
that speculative risks are engaged in voluntarily for gain, and, if they were
insured, the insured would have little incentive to strive to achieve that
gain.
1.1.2 Cause and Effect
Risks may also be considered as being either Particular or Fundamental:
(i) Particular Risks: They have relatively limited consequences, and
affect an individual or a fairly small number of people. The
consequences may be serious, even fatal, for those involved, but are
comparatively localised. Such risks include motor accidents,
personal injuries and the like.
(ii) Fundamental Risks: Their causes are outside the control of any one
individual or even a group of individual, and their outcome affects
large numbers of people. Such risks include famine, war, terrorist
attack, widespread flood and other disasters which are problems for
society or mankind rather than just the ‘particular’ individuals
involved.
The majority of the risks which are insured by commercial insurers are
particular risks. Fundamental risks are not normally insurable because it is
considered financially infeasible for insurers to handle them commercially.
1.1.3 Risk Management
‘Risk management’ is a term which is used with different meanings:
(a) in the world of banking and other financial services outside insurance, it is
probably used with reference to investment and other speculative risks (see
1.1.2a above);
(b) insurance companies will probably use the term only in relation to pure
risks, but they may well restrict it even further to insured risks only. Thus,
when insurers talk about ‘risk management’, they could well be referring
to ways and means of reducing or improving the insured loss potential of
the ‘risks’ they are insuring, or being invited to insure;
(c) as a separate field of knowledge and research, risk management may be
said to be that branch of management which seeks to:
(i) identify;
(ii) quantify; and
(iii) deal with risks (whether pure or speculative) that threaten an
organisation. Tools or measures of risk handling include:
- risk avoidance: elimination of the chance of loss of a certain
kind by not exposing oneself to the peril (e.g. abandoning a
nuclear power project so as to eliminate the risk of nuclear
accidents);
- loss prevention: the lowering of the frequency of identified
possible losses (e.g. activities promoting industrial safety);
- loss reduction: the lowering of the severity of identified possible
losses (e.g. automatic sprinkler system);
- risk transfer : making another party bear the consequences of
one’s exposure to loss (e.g. purchase of insurance and
contractual terms shifting responsibility for possible losses);
- risk financing: no matter how effective the loss control measures
an organisation takes, there will remain some risk of the
organisation being adversely affected by future loss occurrences.
A risk financing programme is to minimise the impact of such
losses on the organisation. It uses tools like: insurance, risk
transfer other than insurance, self-insurance, etc. (Whilst
insurance is closely connected with risk management, it is only one
of the tools of risk management.)
To illustrate (i) - (iii) above, suppose a supermarket finds that it is losing
goods from its shelves. It identifies its possible causes by observation,
which could be theft by customers, theft by staff, etc. It quantifies the loss
from frequent stocktaking compared with cash receipts (making allowance
for staff errors). It may deal with the risk, for example, by installing closed
circuit TV, or (if market conditions allow) by raising prices generally to
offset such losses, or by setting up a self-insurance fund for them.
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