Explain the different types of pure risk and the difference between pure and speculative risk.

Pure risks are defined as situation in which there are only two outcomes that is the possibility of loss or no loss to an organization but no gain - the event either happens or does not happen. When this risk happens, the chance of making any profit is very badly low. Few examples of pure risk are earthquake, theft, accident, fire etc. A car may or may not meet with an accident. If an insurance policy is bought for the car, then if accident occurs the insurance company incurs loss but on the contrary if accident does not occur there is no gain to the insured.

Speculative risks describe situations in which there is a possibility of gain as well as loss. The element of gain is inherent or structured based on the situation. Few examples are gambling on horses, investing in a stock market, merging with an organisation. Thus most of the speculative risks are business related and some speculative risks are optional and can be avoided if desired.

The distinguishing characteristics of pure and speculative risks which is of importance to insurers are the following: The contract of insurance is usually applicable only to pure risks but not to speculative risks. Insurance is meant to assure us against losses that arise as pure risk, but not to outcomes that lead to both loss and gain. Moreover a particular type of risk may appear speculative for the insurance company but a pure risk for the organisation. The law of large numbers is easily applicable to pure risks than to speculative risks. The law is important to insurers since it predicts future loss experience. An exception is the example of gambling, where the casino operators apply the law of large numbers in a most efficient way. Speculative risk may profit the society even if a loss occurs. It carries some inherent advantages to the economy. For example speculative activity in the stock market may lead to more efficient allocation of capital. The same does not apply to pure risk. A fire, flood, earthquake cannot benefit the society. Since pure risk is usually insurable, the discussion on risk is skewed
towards pure risks only. Pure risk is broadly classified into the following four categories:
º Property risk.
º Personal risk.
º Liability risk.
º Loss of income risk.

Property risk
This is a risk to a person in possession of the property which faces loss because of some unforeseen events. Property includes both movable and immovable possessions. Movable assets are personal assets like personal computer, any appliance. Immovable assets are land, building which suffers loss due to natural calamities. Property risk is further divided into direct and indirect loss. Direct loss - A direct loss is defined as a physical damage due to a given calamity or peril in a direct way. For example, if an office building is damaged by fire, the damage incurred in the direct way is the direct loss. Indirect loss - The additional expense incurred due to the destruction of the property is the indirect loss. Thus in addition to the physical damage after a fire, the office would lose profits for several months because of reconstruction. The loss of profits is a consequential loss as a consequence of the damage incurred.

Personal risk
Personal risks are risks that directly affect the individual’s income. This may either be loss of earned income or extra expenditure or depletion of financial assets. There are four major types of personal risks: Risk of premature death. Risk of insufficient income during old age. Risk of poor health. Risk of unemployment.

Risk of premature death - Premature death occurs when the bread earner of a family dies with unfulfilled financial obligations. Therefore this can cause financial problems only if the deceased has dependents to support. There are four costs which results from this. First, the present value of the family’s share of the deceased breadwinner’s future earnings is lost. Secondly, additional expenses like funeral expenses, uninsured medical bills, inheritance taxes can result. Thirdly, due to insufficient income, the family of the deceased has trouble in making ends meet. Finally, intangible costs due to loss of role model, guidance, and counseling result.

Risk of insufficient income during old age - The risk arises when retired people do not have sufficient income after their retirement and it leads to social insecurity. Retired people need to have financial assets from which they can draw income or have access to other sources like private pension.

Risk of poor health - The sudden disability of a person to earn income for living happens to be a disadvantage or sudden risk to that person. The risk of poor health includes payment of medical bills and the loss of earned income. The loss of earned income is a financial insecurity if the disability is severe. Employee benefits may be lost or reduced, savings are depleted and extra care must be taken for the disabled person.

Risk of unemployment - This risk is due to socio-economic factors resulting in financial insecurity. Unemployment results due to business cycle down swings, technology and structure changes in the economy and imperfections in the labor market.

Liability risk
This risk arises to a person when there is a possibility of an unintentional damage caused by him to another person because of negligence. Therefore this risk arises when one’s activity causes adversity to another person. For example, construction of factories or dams which results in dislocating number of villagers. This risk arises due to government regulations and acts. It is quite different from the other risks as there is no maximum upper limit to the amount of the loss. A lien can be placed on one’s income and financial assets to satisfy legal judgment and the cost of legal defense could be huge.

Loss of income risk
This risk is due to an indirect loss from a certain given risk. For example if a firm is not able to operate due to legal issues or destruction by peril, it takes time to resume its normal operations. Therefore in this period, production stoppage will lead to loss of income.