Types of risk.
27 . 08 . 18
By Ignatius Wilson
In life you and your financial assets and belongings are at risk of loss and injury from your own fault, someone else’s or no one’s fault at all. As dry as it sounds, you must already have insurances against these risks through Medicare health insurance and, for car drivers, compulsory third party car insurance (CTP). Here I will unpack the four types of pure risk and what can be done to hedge against these risks.
Before we begin, we need to define pure risk and speculative risk. Pure risk is the chance a damaging or disadvantageous event happens. Speculative risk is the chance a bet doesn’t come off, or an investment doesn’t perform as expected.
Speculative risk cannot be insured against with a literal insurance policy. It can however be ‘insured’ through complex financial instruments which are not insurance policies.These are bundles of financial products to hedge against underperformance or loss.
Personal risk is the pure risk to your health and wellbeing. These risks are either damaging to your health or your bank balance.Slipping over and injuring yourself is a good example. Getting old is also a personal risk but this is something that cannot be really insured against because the loss associated with it is universal and inevitable.
Estate planning is the strategy used to hedge against the risk of financial loss associated with getting old and dying; it ensures the financial assets of the deceased transfer to the right people and with minimum tax and other losses.
Property risk is the pure risk to your belongings and assets. Your home burning down is an example of this. As is the damage a falling tree would do your car parked in the street.
Liability risk is the pure risk of your actions to injure or cause loss to others. Crashing your car into someone else’s is a good example that takes advantage of the CTP cover I mentioned earlier.
Evaluating risk in your own life can be done with the use of a chart plotting the likelihood of an event versus the severity of an event. You can see the likelihood of slipping over is relatively high but the severity of it is relatively low. This contrasts to your home burning down. The likelihood of this happening is extremely low but its severity is extremely high!
While there is some doubt over whether these two risks are worth insuring against, most people do have home and contents insurance which covers damage from fire and flooding and loss through theft.
However an event like a car accident is so likely that the law stipulates CTP is needed and most people add insurances to protect their motor vehicle.
Lastly, there is a pure risk in a legal or commercial context labelled ‘non-performance risk’ whereby a party does not perform as expected and another party suffers a loss due to this. A salaried salesperson who underperforms is an example of this.
I hope this gives an outline of the different types of risk and how they can be insured or hedged against.