Three Types of Risk in Insurance

Having dealt with the meaning of risk we shall now attempt to divert our attention to another aspect of the nature of risk which we shall call as Classification of risk.

It is required to know the complex classification and sub-classification of risk and also an insight on risks which can be insured and which cannot be.

We may look into this subject in the following manner:

  1. Financial and Non-Financial Risks,
  2. Pure and Speculative Risks, and
  3. Fundamental and Particular Risks

In this post we are going to look into the three classification of risk.

Financial and Non-Financial Risks

Financial risks are the risks where the outcome of an event (i.e. event giving birth to a loss) can be measured in monetary terms. The losses can be assessed and a proper money value can be given to those losses. The common examples are:

  • Material damage to property arising out of an event. We may consider damage to a ship due to cyclone or even sinking of a ship due to cyclone. Damage to motor car due to a road accident which may be of partial or total nature. Damage to stock or machinery etc.
  • Theft of a property which may be motor cycle, motor car, machineries, items of household use or even cash.
  • Loss of profit of a business due to fire damaging the material property.
  • Personal injuries due to industrial, road or other accidents resulting into medical costs, Court awards etc.
  • Death of a bread winner in a family leading to corresponding financial hardship.

All such losses, i.e. the outcome of unforeseen untoward events can be measured in monetary terms.

The losses can be replaced, reinstated or repaired or even a corresponding reasonable financial support (in case of death) can be thought about. We would call all such financial risks as insurable risks and these are indeed the main subjects of insurance.

Non-Financial risks are the risks the outcome of which cannot be measured in monetary terms. There may be a wrong choice or a wrong decision giving rise to possible discomfort or disliking or embarrassment but not being capable of valuation in money terms.

Examples can be:

  • Choice of a car, its brand, color etc.
  • Selection of a restaurant menu,
  • Career selection, whether to be a doctor or engineer etc.
  • Choice of bride / bridegroom,
  • Choice of publicity etc.

Since the outcome cannot be valued in terms of money, we shall call these non-financial risks as uninsurable.

Pure Risk and Speculative Risks

Pure risks are those risks where the outcome shall result into loss only or at best a break-even situation. We cannot think about a gain-gain situation.

The result is always unfavorable, or may be the same situation (as existed before the event) has remained without giving a birth to a profit (or loss).

As opposed to this, speculative risks are those risks where there is the possibility of gain or profit. At least the intent is to make a profit and no loss (although loss might ensue).

Investing in shares, may be a good example. Pricing, marketing, forecasting, credit sale etc. are yet examples falling within the domain of speculation.

Consider another example where we can have existence of both pure risks and speculative risks. A garments factory may be in our mind. Here we have:

  • Cyclone damage possibility to the factory building,
  • Fire damage possibility to stock,
  • Machinery breakdown possibility to Machinery,
  • Theft possibility to removable items,
  • Personal accident possibility to factory workers etc.

Also we have:

  • the question of pricing of the product to remain in the competitive market,
  • the question of fashion changes leading to drastic fall in the demand of the product,
  • the question of withdrawal of quota system,
  • the question of credit sale

The students should appreciate that in the first set of examples we are indeed talking about the possibility of certain losses emanating from certain untoward events or unforeseen contingencies (like cyclone, fire, theft, accident etc.) and for convenience we shall call them the risks of trade.

These are identified as pure risks and as such insurable. Notice that these losses can also be measured in monetary terms.

As opposed to this, if we refer to the second set of examples we notice that the outcome of the trade or business is not the result of pure risks but indeed the result of economic factors, supply & demand, change of fashion, trade restriction or liberalization etc. and for convenience we call them trade risks.

These may be identified as speculative risks and usually not insurable.

Fundamental Risk and Particular Risks

Now coming to the last stage of classification of risk we may consider the subject from the viewpoint of cause of a risk and its effect. We call such classifications as fundamental risks and particular risks.

Fundamental risks are the risks mostly emanating from nature. These are the risks which arise from causes that are beyond the control of an individual or group of individuals.

The losses arising out of such causes may be catastrophic in dimension and felt by a huge number of populations, the society or by the state although individual may be a part to that catastrophe. The common examples are:

  • Flood & Cyclone, Subsidence & landslip,
  • Earthquake & volcanic eruption, Tsunami,
  • Convulsion of nature and other natural disasters,
  • Famine, Draught

We may also add in the list perils like war, terrorism, riots & other political activities which are neither created by nature nor by an individual but resulting in colossal losses.

But one thing is certain which are this that all such perils are of impersonal nature not being caused or contributed by an individual or even a group of individuals.

Normally fundamental risks were not supposed to be insurable because of the magnitude and these were considered to be the responsibility of State. Now because of demand and insurers’ strength these risks are easily insurable.

Particular risks are;as opposed to what has been narrated herein before, there are risks which usually arise from actions of individuals or even group of individuals.

These may be identified as causes arising from personal (or group) behavior and effects (losses) not being of that magnitude. These are mostly man created because of their negligence, error in judgment, carelessness, and disregard for law or respect.

We may even go onto suggesting that these are indeed the cases (both cause and effect) where there has been an omission to do something which should have been done or there has been done something which should not have been done. We may call these as risks of personal nature. The common examples are:

  • Fire, Explosion,
  • Burglary, housebreaking, larceny and theft,
  • Stranding, Sinking, Capsizing, Collision in case of a ship, including cargo loss,
  • Machinery breakdown and deterioration of stock due to machinery breakdown,
  • Motor accidents including death and bodily injuries, Industrial accidents,
  • Collapse of bridges, Derailments.

Particular risks are insurable risks and most of the insurances relate to these risks. However, the students should appreciate that risk is a dynamic concept and may be modified because of ever changing situation.

So it may not be unlikely that a risk under one classification is changing its character and identifying itself under another classification.