Risks may be classified in many ways; however, there are certain distinctions that are particularly important for our purposes.
These include the following:
In its broadest context, the term risk includes all situations in which there is an exposure to adversity. In some cases this adversity involves financial loss, while in others it does not. There is some element of risk in every aspect of human endeavour, and many of these risks have no or only incidental financial consequences.
A second important distinction is between static and dynamic risks.
Dynamic risks are those resulting from changes in the economy. Changes in the price level, consumer tastes, income and output, and technology may cause financial loss to members of the economy. These dynamic risks normally benefit society over the long run, since they are the result of adjustments to misallocation of resources. Although these dynamic risks may be affected a large number of individuals, they are generally considered less predictable than static risks, since they do not occur with any precise degree of regularity.
Static risks involve those losses that would occur even if there were no changes in the economy, if we could hold consumer tastes, output and income, and the level of technology constant, some individuals would still suffer financial loss. These losses arise from causes other than the changes in the economy, such as the perils of nature and the dishonesty of other individuals. Unlike dynamic risks, static risks are not a source of gain to society. Static losses involve either the destruction of the asset or a change in its possession as a result of dishonesty or human failure. Static losses tend to occur with a degree of regularity over time and, as a result, are generally predictable. Because they are predictable, static risks are more suited to treatment by insurance than are dynamic risks.
The distinction between fundamental and particular risks is based on the difference in the origin and consequences of the losses.
Fundamental risks involve losses that are impersonal in origin and consequence. The yare group risks caused fro the most part by economic, social, and political phenomena, although the y may also result from physical occurrences. They affect large segments or even all of the population. Particular risks involve losses that arise out of individual events and are felt by individuals rather than by entire group. They may be static or dynamic. Unemployment, war, inflation, and floods are all fundamental risks. The burning of a house and the robbery of a bank are particular risks.
Since fundamental risks are caused by conditions more or less beyond the control of the individuals who suffer the losses and since the y are not the fault of anyone in particular, it is held that society rather than the individual has a responsibility to deal with them. Although some fundamental risks are dealt with though private insurance, it is an inappropriate tool for dealing with most fundamental risks. Usually, some form of social insurance or other government transfer program is used to deal with fundamental risks. Unemployment and occupational disabilities are fundamental risks treated through social insurance. Flood damage or earthquakes make a district a disaster area eligible for federal funds.
Particular risks are considered to be the individual's own responsibility, inappropriate subjects for action by society as a whole. They are dealt with by the individual through the use of insurance, loss prevention, or some other technique.
One of the most useful distinctions is that between pure risk and speculative risk. Speculative risk describes a situation where there is a possibility of loss, but also a possibility of gain. Gambling is a good example of a speculative risk. In a gambling situation, risk is deliberately created in the hope of gain. The person wagering $10 on the outcome of a game faces the possibility of loss, but this is accompanied by the possibility of gain. The entrepreneur or capitalist faces speculative risk in the quest for profit. The investment made may be lost if the product is not accepted by the market at a price sufficient to cover costs, but this risk is borne in return for the possibility of profit. The term pure risk, in contrast, is used to designate those situations that involve only the chance of loss or no loss. One of the best examples of pure risks is the possibility of loss surrounding the ownership of property. The person who buys an automobile, for example, immediately faces the possibility that something may happen to damage or destroy the automobile. The possible outcomes are loss or no loss.
The distinction between pure and speculative risks is an important one, because normally only pure risks are insurable. Insurance is not concerned with the protection of individuals against those losses arising out of speculative risks. Speculative risk is voluntary accepted because of its two-dimensional nature, which includes the possibility of gain. Not all pure risks are insurable, and a further distinction between insurable and uninsurable pure risks may also be made.
While it would be impossible to list all the risks confronting an individual or business, we can briefly outline the nature of the various pure risks that we face. For the most part, these are also static risks. Pure risks that exist for individuals and business firms can be classified under one of the following:
These consist of the possibility of loss of income or assets as a result of the loss of the ability to earn income. In general, earning power is subject to four perils:
- premature death,
- dependant old age,
- sickness or disability, and
- unemployment
Anyone who owns property faces property risks simply because such possessions can be destroyed or stolen. Property risks embrace two distinct types of loss: direct loss and indirect or "consequential" loss. Direct loss is the simplest to understand: if a house is destroyed by fire, the owner loses the value of the house. This is a direct loss. However, in addition to losing the value of the building itself, the property owner no longer has a place to live, and during the time required to rebuild the house, it is likely that the owner will incur additional expenses living somewhere else. This loss of use of the destroyed asset is an indirect, or "consequential," loss. An even better example is the case of a business firm. When a firm's facilities are destroyed, it loses not only the value of those facilities but also the income that would have been earned through their use. Property risks, then, can involve two types of losses:
- the loss of the property, and
- loss of use of the property resulting in lost income or additional expenses
Liability risks
The basic peril in the liability risk is the unintentional injury of other persons or damage to their property through negligence or carelessness; however, liability may also result from intentional injuries or damage. Under our legal system, the laws provide that one who has injured another, or damaged another's property through negligence or otherwise, can be held responsible for the harm caused. Liability risks therefore involve the possibility of loss of present assets or future income as a result of damage assessed or legal liability arising out of either intentional or unintentional torts, or invasion of the rights of others.
When another person agrees to perform a service for you, he or she undertakes and obligation that you hope will be met. When the person's failure to meet this obligation would result in your financial loss, risk exists. Examples of risks in tis category would include failure of a contractor to complete a construction project as scheduled, or failure of debtors to make payments as expected.
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