The Concept of Risk
Risk is the foundation of the entire insurance industry. Understanding risk—what it is, the different types, and how it's measured—is essential for anyone entering the insurance field.
What Is Risk?
Risk is the possibility of financial loss. In insurance terms, risk represents uncertainty about whether a loss will occur and, if it does, how severe it will be.
Every person and business faces risk daily. You might get sick, your car might be in an accident, or your house might catch fire. Insurance exists because people want protection against these uncertain but potentially devastating financial losses.
Pure Risk vs. Speculative Risk
Not all risks are insurable. Understanding the difference between pure and speculative risk is crucial for the exam.
| Risk Type | Definition | Insurable? | Examples |
|---|---|---|---|
| Pure Risk | Presents only the possibility of loss or no loss—no chance of gain | Yes | Death, illness, accident, fire, theft |
| Speculative Risk | Presents the possibility of loss, gain, or breaking even | No | Gambling, stock market investments, starting a business |
Pure Risk
Pure risk involves situations where there are only two possible outcomes: loss or no loss. There is no opportunity for financial gain. These are the only risks that insurance companies will cover.
Examples of pure risks:
- The risk of dying prematurely
- The risk of becoming disabled and unable to work
- The risk of a car accident causing injury
- The risk of a house fire destroying property
Speculative Risk
Speculative risk involves the possibility of gain as well as loss. Because there's an opportunity for profit, insurance companies won't cover speculative risks—it would essentially be gambling.
Examples of speculative risks:
- Investing in the stock market (you could gain or lose money)
- Starting a new business (you could succeed or fail)
- Gambling at a casino (you could win or lose)
Exam Tip
If an exam question asks which type of risk is insurable, the answer is always pure risk. Remember: insurance protects against loss, not the chance of missing out on gain.
Perils
A peril is the immediate, specific cause of a loss. It's the event that actually causes the damage or harm.
Common perils include:
- Death
- Sickness or disease
- Accident or injury
- Fire
- Windstorm
- Theft
- Flood
When you purchase insurance, you're buying protection against specific perils. For example, life insurance protects against the peril of death, while health insurance protects against the perils of sickness and injury.
Hazards
A hazard is any condition or situation that increases the likelihood that a peril will occur. While a peril is the cause of loss, a hazard is something that makes that loss more probable or more severe.
Types of Hazards
| Hazard Type | Definition | Examples |
|---|---|---|
| Physical Hazard | Tangible, physical conditions that increase the chance of loss | Icy sidewalk, faulty wiring, obesity, high blood pressure |
| Moral Hazard | Dishonesty or character defects that increase risk | Intentionally causing a loss to collect insurance, exaggerating claims, fraud |
| Morale Hazard | Carelessness or indifference to loss because insurance exists | Texting while driving, leaving doors unlocked, not maintaining property |
Physical Hazard
Physical hazards are tangible conditions that make loss more likely. In life and health insurance, physical hazards often relate to a person's health or occupation.
Examples:
- A history of heart disease (increases risk of death)
- Working in a dangerous occupation like mining
- Being significantly overweight
- Living in a high-crime area
Moral Hazard
Moral hazard involves intentional dishonesty or unethical behavior. This is the most serious type of hazard because it involves deliberate attempts to cause or exaggerate losses.
Examples:
- Lying on an insurance application about health conditions
- Staging an accident to collect benefits
- Exaggerating the extent of a disability claim
- Arson to collect property insurance
Morale Hazard
Morale hazard (note: morale, not moral) involves carelessness or indifference that increases risk. People sometimes take fewer precautions because they know they're insured.
Examples:
- Not locking your car because you have theft insurance
- Eating unhealthy food because health insurance will cover medical bills
- Not maintaining smoke detectors because you have fire insurance
- Texting while driving because you have auto insurance
Exam Tip
Don't confuse moral and morale hazards:
- Moral = intentional dishonesty (think "morality" - right vs. wrong)
- Morale = carelessness (think "morale" - attitude or spirit)
Key Takeaways
- Risk is the possibility of financial loss
- Pure risks (loss or no loss) are insurable; speculative risks (chance of gain) are not
- A peril is the cause of loss (fire, death, accident)
- A hazard is a condition that increases the likelihood of loss
- The three types of hazards are physical, moral (dishonesty), and morale (carelessness)
Which of the following is an example of a pure risk?
An applicant lies about their smoking history on a life insurance application. This is an example of:
A person doesn't bother to lock their front door because they have homeowners insurance. This is an example of:
1.2 Risk Management
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