Risks, Perils, and Hazards

Risk, peril, and hazard are terms used to indicate the possibility of loss,
and are often used interchangeably, but the insurance industry distinguishes
these terms. A Risk is simply the possibility of a loss, but a peril is a cause of
loss. A hazard is a condition that increases the possibility of loss. For
instance, fire is a peril because it causes losses, while a fireplace is a hazard
because it increases the probability of loss from fire. Some things can be
both a peril and a hazard. Smoking, for instance, causes cancer and other
health ailments, while also increasing the probability of such ailments. Many
fundamental risks, such as hurricanes, earthquakes, or unemployment, that
affect many people are generally insured by society or by the government,
while particular risks that affect individuals or specific organizations, such as
losses from fire or vandalism, are considered the particular responsibilities of
those affected.

Types of Risk

There are different types of risks — only some are preventable, and only
certain types of risk are insurable. Risk can be categorized as to what causes
the risk, 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. Pure risk is insurable, because the law of large numbers can be
applied to estimate future losses, which allows insurance companies to
calculate what premium to charge based on expected losses

Static and dynamic risks are distinguished by their temporality. The

possibility of loss is uniform over an extended period of time for static risks,
so static risks are more predictable, and, therefore, more
insurable. Dynamic risks change with time, making them less predictable
and less insurable. For instance, the risk of unemployment changes with the
economy, so it is difficult to predict what unemployment will be next year.
On the other hand, the number of houses that burn down within a given year
within a specific geographical area is steadier, not cyclical, and so is more
predictable.
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 there is the possibility of
profit or loss, such as investing in financial markets. Most speculative risks
are uninsurable, because they are undertaken willingly for the hope of profit.
Also, speculative risk will generally involve a greater frequency of loss than a
pure risk, since profit is the only other possibility. So although many people
take precautions to protect their lives or their property, they willingly engage
in speculative risks, such as investing in the stock market, to make a profit;
otherwise, a person could avoid most speculative risks simply by avoiding the
activity that gives rise to it.

The speculative risk of investments can also be distinguished as systemic

risk (a.k.a. systematic risk) or diversifiable risk (a.k.a. unsystematic
risk). Systemic risk affects the whole economy, causing the value of many
financial instruments to lose value. Diversifiable risk, on the other hand,
affects only specific investments, such as particular stocks or particular
assets. It is called a diversifiable risk because this risk can be minimized by
diversifying investments, by not putting all your eggs in one basket. By
contrast, systemic risk cannot be diversified away, because it affects almost
all investments. Systemic risk can be minimized if the investments are
diversified and held long enough, since the value of most investments, like
businesses, goes through cycles.

Unlike pure risk, where there is only possibility of a loss, society benefits
from speculative risks. For instance, investments benefit society, and starting
a business helps to create jobs and generate tax revenue for society, and can
lead to economic growth, or even technological advancement.

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
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
Peril and Hazard

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

nsurance 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. A good example of morale hazard is when the
federal government bails out financial institutions who have made bad
decisions. Many financial institutions have taken significant risks in the recent
subprime debacle by buying toxic instruments, such as Collateralized Debt
obligations and mortgage-backed securities based on subprime mortgages
that paid high yields, but were extremely risky. The financial institutions
have considered themselves too big to fail—in other words, if things started
going badly, then the federal government would step in to stop their collapse
for fear that the whole financial system will collapse, which is exactly what
the federal government did in September, 2008. Freddie Mac and Fannie Mae
have both been taken over by the government, and American International
Group (AIG) has been propped up by an infusion of $85 billion of taxpayers'
money. AIG sold credit default swaps on mortgage-backed securities to
buyers, mostly banks, thinking that they could collect the premiums, but
would never have to actually to pay for defaults—but if they were wrong,
then the government would save them, because otherwise the banks that
had bought that credit default protection could also possibly fail. As recent
events have demonstrated all too clearly, this federal government
"insurance" creates a morale hazard for financial institutions—taxpayers pay
the premium, but the big financial institutions, with their overpaid CEOs and
managers, receive the benefits!

Distinction Between Moral Hazard and Morale Hazard

The distinction between moral and morale hazard in insurance is one of

intention, but in other disciplines, such as banking, the term moral hazard is
used in a more general sense that includes morale hazard. Moral hazard is
often applied to a receiver of funds, such as a borrower, and means that
there is a risk that the receiver of funds will not use the money as was
intended or that they may take unnecessary risks or not be vigilant in
reducing risk. This definition includes not only intentional dishonesty, but
also a change in behaviour that results from using someone else's money,
which, in insurance, would be described as morale hazard.