Skip to main content

TYPES OF RISK



There are different types of risk.  The most important types of risk include:
(i)                  Pure Risk
(ii)                Speculative Risk
(iii)               Particular Risk
(iv)              Fundamental Risk
(v)               Static Risk
(vi)              Dynamic Risk.

PURE RISK

Pure risk is a situation that holds out only the possibility of loss or no loss or no loss.  For example, if you buy a new textbook, you face the prospect of the book being stolen or not being stolen.  The possible outcomes are loss or no loss.  Also, if you leave your house in the morning and ride to school on your motorcycle you cannot be sure whether or not you will be involved in an accident, that is, you are running a risk.  There is the uncertainty of loss.  Your motorcycle may be damaged or you may damage another person’s property or injured another person.  If you are involved in any one of these situations, you will suffer loss.  But if you come back home safely without any incident, then you will suffer no loss.  So in pure risk, there is only the prospect of loss or no loss.  There is no prospect of gain or profit under pure risk.  You derive no gain from the fact that your house is not burnt down.  If there is no fire incident, the status quo would be maintained, no gain no loss, or a break-even situation.  Therefore, it is only the pure risks that are insurable.

Different Types of Pure Risk

Both the individual and business firms face different types of pure risks that pose great threat to their financial securities.  The different types of pure risks that we face can be classified under any one of the followings:

(i)                  Personal risks
(ii)                Property risks
(iii)               Liability risks

Personal Risks

Personal risks are those risks that directly affect an individual. 
Personal risks detrimentally affect the income earning power of an individual.  They involve the likelihood of sudden and complete loss of income, or financial assets sharp increase in expenses or gradual reduction of income or financial assets and steady rise in expenses.  Personal risks can be classified into four main types:

(i)                  Risk of premature death
(ii)                Risk of old age
(iii)               Risk of sickness
(iv)              Risk of unemployment


·         Risk of Premature Death

It is generally believed that the average life span of a human being is 70 years.  Therefore, anybody who dies before attaining age 70 years could be regarded as having died prematurely.  Premature deaths usually bring great financial and economic insecurity to dependants.  In most cases, a family breadwinner who dies prematurely has children to educate, dependants to support, mortgage loan to pay.  In addition, if the family bread-winner dies after a protracted illness, then the medical cost may still be there to settle and of course the burial expenses must have to be met.  By the time all these costs are settled, the savings and financial assets of the family head may have been seriously depleted or possibly completely spent or sold off and still leaving a balance of debt to be settled.

The death of family head could render some families destitute and sometimes protracted illness could so much drain the financial resources of some families and impoverish them even before the death of the family breadwinner.

When a family breadwinner dies, the human-life value of the breadwinner would be lost forever.  This loss is usually very considerable and creates grate financial and economic insecurity.  What is a human life value?  A human life value is the present value of the share of the family in the earnings of the family head.

·         Risk of Old Age

The main risk of old age is the likelihood of not getting sufficient income to meet one’s financial needs in old age after retirement.  In retirement, one would not be able to earn as much as before and because of this, retired people could be faced with serious financial and economic insecurity unless they have build up sufficient savings or acquired sufficient financial assets during their active working lives from which they could start to draw in old age.

Even some of the workers who make sufficient savings for old age would still have to contend with corrosive effect of inflation on such savings.  High rate of inflation can cause great financial and economic distress to retired people as it may reduce their real incomes.

·         Risk of Poor Health

Everybody is facing the risk of poor health.  It is only when people are healthy, that they can meaningfully engage themselves in any productive activity an earn full economic income.  Poor health can bring serious financial and economic distress to an individual.  For example, without good health, nobody can gainfully engage himself in any serious economic undertaking an maximized his economic income. 

A sudden and unexpected illness or accident can result in high medical bills.  Therefore, poor health will result in loss of earned income and high medical expenses.  And unless the person has adequate personal accident and health insurance cover or has made adequate financial arrangements for income from other sources to meet these expenses, the person will be financially unsecured.



·         Risk of Unemployment

The risk of unemployment is a great threat to all those who are working for other people or organizations in return for wages or salaries.  The risk equally poses a great threat to all those who are still in school or undergoing courses of vocational training with the notion of taking up salaried job after the training period.  Self-employed persons, whose services or products are no longer in demand, could also be faced with the problem of unemployment.

Unemployment is a situation where a person who is willing to work and is looking for work to do cannot find work to do.  Unemployment always brings financial insecurity to people.  This financial insecurity could come in many ways, among which are:

(i)                  The person would lose his or her earned income.  When this happens, he will suffer some financial hardship unless he has previously built up adequate savings on which he can now start to draw.
(ii)                If the person fails to secure another employment within reasonable period of time, he may fully deplete his savings and expose himself to financial insecurity.
(iii)               If he secures a part-time job, the pay would obviously be smaller than the full-time pay and this entails a reduction of earned income.  This would also bring financial insecurity.


SPECULATIVE RISK

Speculative risk is a situation that holds out the prospects of loss, gain, or no loss no gain (break-even situation).  Speculative risks are very common in business undertakings.  For example, if you establish a new business, you would make a profit if the business is successful and sustain loss if the business fails.

If you buy shares in a company you would make a gain if the price of the shares rises in the stock market, and you would sustain a loss if the price of the shares falls in the market.  If the price of the shares remains unchanged, then, you would not make a profit or sustain a loss.  You break-even.  Gambling is a good example of speculative risk.  Gambling involves deliberate creation of risk in the expectation of making a gain.  There is also the possibility of sustaining a loss.  A person betting $500 on the outcome of the next weekend English Premier League Match faces both the possibility of loss and of gain and of no loss, no gain. Most speculative risks one dynamic risk with the exception of gambling situations.

Other examples of speculative risk include taking parts in a football pool, exporting to a new market, betting on horse race or motor race.

Speculative risks are no subject of insurance, and then are therefore not normally insurable.  They are voluntarily accepted because of their two-dimensional nature of gain or loss.








Pure Risk
Speculative Risk
1.        Pure risk is a risk where there is only the possibility of a loss or you maintain a status quo.  Only pure risks are insurable.
1.       Speculative risk is a risk where both profit and loss are possible.  Speculative risks are not normally insurable.

The few exceptions of speculative risks are insurable firms that insure their institutional portfolio of investments against loss.
2.        Although there are some exceptions of pure risks which are not insurable.
2.       Speculative risks are not generally    easily predictable.  So, the law of large numbers cannot be easily applied to speculative risk.

However, gambling is one exception of speculative risks to which the law of large numbers can easily be efficiently applied.

Society may benefit from a speculative risk if a loss occurs.  For example, a firm may develop a new invention for producing a commodity more cheaply.  As a result of this, a competitor may be forced out of the market into bankruptcy.  In this situation, the society will benefit since the products are produced more efficiently and at lower cost to consumers, even though competitor has been forced into bankruptcy.

Speculative risks are more voluntarily accepted because of its two-dimensional nature of gain or loss.
3.       Pure risk are generally easily predictable than speculative risks.  So the application of the law of large numbers can be more easily applied to pure risk.

4.       Society will not benefit from a pure risk if a loss occurs.  For example, if a flood or earthquake devastates a region, society will not benefit from such devastation.

5.       Pure risk is not voluntarily accepted.



Liability Risks

Most people in the society face liability risk.  The law imposes on us a duty of care to our neighbour and to ensure that we do not inflict bodily injury on them.  If anyone breaches this duty of care, the law would punish him accordingly.  For example, if you injure your neighbour or damage his property, the law would impose fines on you and you may have to pay heavy damages.

Unfortunately, one can be found liable for breach of duty of care in different ways and the best security seems to be the purchase of liability insurance cover.

Liability Risks have two peculiarities:

(i)                  Under liability risk, the amount of loss that can be involved has no maximum upper limit.
The wrong doer can be sued for any amount.  For example, while riding on your bicycle valued $500, you negligently cause serious bodily injury to another person, that person can sue you for any amount of money, say $5000, N10,000 or even more depending on the nature of the injury.

In contrast, if the bicycle value at $500 is completely damaged by another person, the maximum amount of compensation (indemnity) that would be paid to you for the loss of the bicycle is jus $500, that is, the actual value of the bicycle.

ii.          Under liability risks your future income and assets may be attached to settle a high court fines if your present income and assets are inadequate to pay the judgment debt.  When this happens, your financial and economic security would be greatly endangered.

Property Risks

Property owners face the risk of having their property stolen, damaged or destroyed by various causes.  A property may suffer direct loss, indirect loss, losses arising from extra expenses of maintaining the property or losses brought about by natural disasters.

Natural disasters such as flood, earthquake, storm, fire etc can bring about enormous property losses as well as taking several human lives.  The occurrence of any of these disasters can seriously undermine the financial security of the affected individual, particularly if such properties are not unsecured.

Direct Loss

Direct loss is that loss which flows directly from the unsecured peril.  For example, if you insure your house against fire, and the house is eventually destroyed by fire, then the physical damage to the property is known as direct loss.

Indirect Loss or Consequential Loss

Indirect or consequential loss is a loss that arises because of a prior occurrence of another loss.  Indirect loss flows directly from an earlier loss suffered.  The loss is the consequence of some other loss.  It arises as an additional loss to the initial loss suffered.  For example, if a factory that has a fire policy suffers a fire damage, some physical properties like building, machinery maybe destroyed.  The loss of these properties flows directly from the insured peril (fire).  The physical damage to the properties is known as direct fire loss.

But in addition to the physical damage to the properties, the firm may stop production for several months to allow for the rebuilding of the damaged of the premises and replacement of damaged equipment, during which no profit would be earned.

This loss of profit is a consequential loss.  It Is not directly brought about by fire but flows directly from the physical damage brought about by fire and hence indirectly from the fire incident.  Other examples of consequential loss are the loss of the use of the building and the loss of a market.

Extra Expenses

Alternative arrangement may have to be made to rend a temporary premises, pending the repairs or reinstatement of the damaged building, and it may also be necessary to rent, hire or lease a machine in order to keep production going so as not to disappoint customers and in the process lose market to competitors. The expenses incurred in securing the alternative premises, an renting, hiring or leasing a machine are referred to as extra expenses.  These expenses may not have been insured if there has been no fire damage.



FUNDAMENTAL RISK

A fundamental risk is a risk which is non-discriminatory in its attack and effect. It is impersonal both in origin and consequence.  It is essentially, a group risk caused by such phenomena like bad economy, inflation unemployment, war, political instability, changing customs, flood, draught, earthquake, weather (e.g. harmattan) typhoon, tidal waves etc.  They affect large proportion of the population and in some cases they can affect the whole population e.g. weather (harmattan for example).  The losses that flow from fundamental risks are usually not caused by a particular individual and the impact of their effects falls generally on a wide range of people or on everybody.  Fundamental risk arise from the nature of the society we live in or from some natural occurrences which are beyond the control of man.

The striking peculiarity of fundamental risk is that is incidence is non-discriminatory and falls on everybody or most of the people.  The responsibility of dealing with fundamental risk lies with the society rather than the individual.  This is so because, fundamental risks are caused by conditions which are largely beyond human’s control and are not the fault of anyone in particular.  The best means of handling fundamental risk is the social insurance, as private insurance is very inappropriate.  Although, it is on record that some fundamental risk, like earthquake, flood are being handle by private insurance.


PARTICULARS RISKS

A particular risk is a risk that affects only an individual and not everybody in the community.  The incidence of a particular risk falls on the particular individual affected.  Particular risk has its origin in individual events and its impact is localized (felt locally).  For example, if your textbook is stolen, the full impact of the loss of the book is felt by you alone and not by the entire members of the class.  You bear the full incidence of the loss.  The theft of the book therefore is a particular risk. 
If your shoes are stolen, the incidence of the loss falls on you and not on any other person.  Particular risks are the individual’s own responsibility, and not that of that society or community as a whole.  The best way to handle particular risk by the individual is the purchase of insurance cover.

STATIC RISK

Static risks are risks that involve losses brought about by irregular action of nature or by dishonest misdeeds and mistakes of man.  Static losses are present in an economy that is not changing (static economy) and as such, static risks are associated with losses that would occur in an unchanging economy.  For example, if all economic variables remain constant, some people with fraudulent tendencies would still go out steal, embezzle funds and abuse their positions.  So some people would still suffer financial losses.  These losses are brought about by causes other than changes in the economy.  Such as perils of nature, and the dishonesty of other people.

Static losses involve destruction of assets or change in their possession as a result of dishonesty.  Static losses seem to appear periodically and as a result of these they are generally predictable.  Because of their relative predictability, static risks are more easily taken care of, by insurance cover then are dynamic risks.  Example of static risk include theft, arson assassination and bad weather.  Static risks are pure risks.

DYNAMIC RISK

Dynamic risk is risks brought about by changes in the economy.  Changes in price level, income, tastes of consumers, technology etc (which is examples of dynamic risk) can bring about financial losses to members of the economy.  Generally dynamic risks are the result of adjustments to misallocation of resources.  In the long run, dynamic risks are beneficial to the society.  For example, technological change, which brings about a more efficient way of mass producing a higher quality of article at a cheaper price to consumers than was previously the case, has obviously benefited the society.
Dynamic risk normally affects a large number of individuals, but because they do not occur regularly, they are more difficult to predict than static risk.

DIFFERENCE BETWEEN DYNAMIC RISK AND STATIC RISK

Static Risk
Dynamic Risk
1.       Most static risks are pure risks
1.        They are mainly speculative risks.
2.       They are easily predictable
2.   They are not easily predictable
3.       The society derives no benefit or gain   from static risk.  Static risks are always harmful.
3.     The society derives some benefits from   
       dynamic risk.
4.       Static risks are present in an unchanging economy.
4.    Dynamic risks are only present in a
       changing economy
5.       Static risks affect only individuals or very few individuals.
5.       Dynamic risk affect large number of
        Individuals.

Comments

Popular posts from this blog

10 Common Car Insurance Terminologies You Must Know About

  Due to a lack of information on particular words specified in the car insurance policy document, most car owners buy a car insurance policy based on its coverage and premium but do not grasp its terms and conditions. As a result, using the policy becomes more difficult. As a result, before acquiring a vehicle insurance plan, it is advisable to familiarise yourself with the most prevalent car insurance dictionary words. To help you make an informed decision, let's look at some of the most common phrases related to vehicle insurance. Terms Commonly Used Among the often used terms are: ·          Covers with Add-ons Additional insurance coverage, known as add-ons or riders, can be purchased in addition to a Comprehensive Plan. These plans are not available as a standalone cover or in combination with a Third-Party Plan. Coverage or service-related add-on covers are also possible. A Zero Depreciation Add-on, for example, is more of a coverage-enhancing add-on, whereas a Roads

Business Insurance Basics

Business Insurance Basics Most businesses need to purchase at least the following four types of insurance:  1. Property Insurance Property insurance compensates a business if the property used in the business is lost or damaged as the result of various types of common perils, such as fire or theft. Property insurance covers not just a building or structure but also the contents, including office furnishings, inventory, raw materials, machinery, computers and other items vital to a business’s operations. Depending on the type of policy, property insurance may include coverage for equipment breakdown, removal of debris after a fire or other destructive event, some types of water damage and other losses.  Business Interruption Insurance  Also known as business income insurance, business interruption insurance is a type of property insurance. A business whose property has sustained a direct physical loss such as fire damage or a damaged roof due to a tree falling on it in a windstorm and h

The Burden of Risk

The Burden of Risk The presence of risks saddles on the individual and society some measure of social and economic pains.  Every risk holds the prospect of actually resulting in some economic losses and in addition some social pains. When a house is destroyed by fire, or a vehicle is ruined in a crash, or a breadwinner dies or money is stolen or you negligently injure a person or damage his property, financial losses would be involved.  In addition to the financial cost of losses brought about by risk, there is the pain of fears and worries resulting from the uncertainty as to whether or not loss would occur.  All these underwrite the need why a prudent individual and society should prepare for a possible occurrence of loss.  The greatest burden of risk, therefore is loss. Risk put three major burden on the society: (i)                   The creation of adequate contingency (ii)                 Deprivation of society of needed goods and services (iii)                The creation of per