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Risk can be categorized as to why the risk exists, and to whom it affects.
Pure risk is a risk in which there is only a possibility of loss or no loss—there is no possibility of gain. Pure risk can be categorized as personal, property, or legal risk.
Personal risks are risks that affect someone directly, such as illness, disability, or death. Property risk affects either personal or real property. Thus, a house fire or car theft are examples of property risk. A property loss often involves both a direct loss and consequential losses. A direct loss is the loss or damage to the property itself. A consequential loss (aka indirect loss) is a loss created by the direct loss. Thus, if your car is stolen, that is a direct loss; if you have to rent a car because of the theft, then you have some financial loss—a consequential loss—from renting a car.
Legal risk (aka liability risk) is a particular type of personal risk that you will be sued because of neglect, malpractice, or causing willful injury either to another person or to someone else’s property. Legal risk is the possibility of financial loss if you are found liable, or the financial loss incurred just defending yourself, even if you are not found liable. Most personal, property, and legal risks are insurable.
Speculative risk differs from pure risk because these is the possibility of profit or a loss. This characterizes most financial investments. Most speculative risks are uninsurable, because they are undertaken willingly for the hope of profit.
Pure risk is insurable, because the law of large numbers can be applied to forecast future losses, and, thus, insurance companies can calculate what premium to charge based on expected losses. On the other hand, speculative risks have more varied conditions that make estimating future losses difficult or impossible. Also, speculative risk will generally involve a greater frequency of loss than a pure risk. For instance, people do many things to protect their lives, or their property, but people willingly engage in speculative risks, such as investing in the stock market, to make a profit; otherwise, a person can avoid most speculative risks simply by avoiding the activity that gives rise to it.
However, unlike pure risk, society benefits from speculative risks. Investments benefit society, or the risk of starting a business helps to create jobs and pay taxes for society, and can lead to economic growth, or even technological advancement. Because the only possibility of a pure risk is loss or no loss, there is no possibility of a gain.
Risk can also be classified as to whether it affects many people or only a single individual. Fundamental risk is a risk, such as an earthquake or terrorism, that can affect many people at once. Economic risks, such as unemployment, are also fundamental risks because they affect many people. Particular risk is a risk that affects particular individuals, such as robbery or vandalism. Insurance companies generally insure some fundamental risks, such as hurricane or wind damage, and most particular risks. In the case of fundamental risks that are insured, insurance companies help to reduce their risk of great financial loss by limiting coverage in a specific geographic area and by the use of reinsurance, which is the purchase of insurance from other companies to cover their potential losses. However, private insurers do not insure many fundamental risks, such as unemployment. These risks are generally insured by the government, because the government has some control over economic risks through specific policies, such as monetary policy, and law. Fundamental and particular risks can be pure or speculative risks.
Fundamental risks are risks that affect many members of society, but fundamental risks can also affect organizations. For instance, enterprise risk is the set of all risks that affects a business enterprise. Speculative risks that can affect an organization are usually subdivided into strategic risk, operational risk, and financial risk. Strategic risk results from goal-oriented behavior. A business may want to try to improve efficiency by buying new equipment or trying a new technique, but may result in more losses than gains. Operational risks arise from the operation of the enterprise, such as the risk of injury to employees, or the risk that customers’ data can be leaked to the public because of insufficient security. Financial risk is the risk that an investment will result in losses. Because most enterprise risk is a speculative risk, and because the enterprise itself can do much to lower its own risk, many companies are learning to manage their risk by creating departments and hiring people with the express purpose of reducing enterprise risks—enterprise risk management. Many larger firms may have a chief risk officer (CRO) with the primary responsibility of reducing risk throughout the enterprise.
Risk is the chance of loss, and peril is the direct cause of the loss. If a house burns down, then fire is the peril. A hazard is anything that either causes or increases the likelihood of a loss. For instance, gas furnaces are a hazard for carbon monoxide poisoning. A physical hazard is a physical condition that increases the possibility of a loss. Thus, smoking is a physical hazard that increases the likelihood of a house fire and illness.
Moral hazards are losses that results from dishonesty. Thus, insurance companies suffer losses because of fraudulent or inflated claims. The American legal system is a moral hazard in that it motivates many people to sue simply for financial profit because of the enormous amount of money that can sometimes be won, and because there is little cost to the plaintiff even if he loses. A good example is the current asbestos litigation, which has bankrupted many companies, even though very few plaintiffs show any real evidence of disease, and are unlikely to ever develop any disease that can be shown, by the preponderance of the evidence, to have resulted from asbestos exposure. This type of moral hazard is often referred to as legal hazard. Legal hazard can also result from laws or regulations that force insurance companies to cover risks that they would otherwise not cover, such as including coverage for alcoholism in health insurance.
Insurance can be regarded as a morale hazard because it increases the possibility of a loss that results from the insured worrying less about losses. Therefore, they take fewer precautions and may engage in riskier activities—because they have insurance.
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