Characteristics of risks
Risks can be characterised in three main ways, according to:
- dynamic risks versus static risks
- fundamental versus particular risks
- pure versus speculative risks.
Dynamic versus static risks
Dynamic risks are uninsurable risks arising from the continuous change in the business or economic environment.
For example, changes in price levels, consumer tastes and technology may cause financial loss to business or individuals.
Static risks are generally insurable and involve losses that would occur even if there were no changes in the economy (for example, fire, accidents or dishonesty).
Fundamental versus particular risks
Fundamental risks are impersonal and involve large sections of the community (for example, unemployment, war, earthquakes and flood damage). Fundamental risks are mainly caused by social, economic and political events and can also result from physical occurrences. While some fundamental risks can be handled by insurance, they are usually dealt with by the government (they are a community concern).
Read a short case study of earthquakes as a fundamental risk.
Particular risks are exposures to loss from a situation associated with specific individual events (personal in origin and consequence). Individuals mitigate particular risks through loss prevention and insurance (for example).
Case Study: Earthquakes – A fundamental risk
New Zealand (NZ) lies on a major fault line, meaning earthquakes are expected but unpredictable.
NZ earthquakes fail insurability criteria on the basis of being non-fortuitous. To contextualise this, Wellington experiences 15 minor earthquakes per day on average, and major earthquakes can and do occur.
For these reasons, earthquakes in New Zealand constitute a fundamental risk.
The New Zealand Government assists insurers to cover the risk of an earthquake through the Earthquake Commission Scheme, which covers the first:
- $100,000 of every house insured (plus GST)
- $20,000 of every contents policy (plus GST).
Pure versus speculative risks
The distinction between pure and speculative risks is perhaps the most useful delineation for insurance purposes.
Pure risks relate to situations involving either a loss or no loss, without any attainable gain from the risk exposure.
For example, your house may burn down or your car may be damaged—there is no real gain for you in these situations—only loss or absence of a loss.
For this reason, most pure risks are insurable.
Most speculative risks are uninsurable and involve a possibility of both loss and gain.
To start a business is a good example of a speculative risk. Before you take the step to start the business, there is no risk. However, once you take that step, you can only fail or succeed.
An insurance policy may provide the incentive to claim (moral hazard) by creating a win-win situation.