What is pure risk?
Pure risk refers to risks that are beyond human control and result in a loss or no loss with no possibility of financial gain. Fires, floods and other natural disasters are categorized as pure risk, as are unforeseen incidents, such as acts of terrorism or untimely deaths.
Risk managers deal with risk in four basic ways: They reduce it, avoid it, accept it or transfer it. Many types of pure risk are dealt with by purchasing insurance coverage for the potential loss, which transfers the risk to an insurance company.
What are examples of pure risk?
Pure risk, also referred to as absolute risk, is usually divided into three categories:
- Personal pure risks are risks affecting an individual that result in a loss or reduction of personal assets. Unemployment is an example of pure risk. An illness that requires expensive medical treatment and thus reduces personal assets is another example. Other types of personal pure risk include a house fire, disability and premature death.
- Property pure risks include the potential of fire, floods, hurricanes and other natural disasters to damage or destroy property, including buildings and the contents of buildings. The loss of property due to theft also falls into this category. Property pure risk can incur both direct and indirect losses, as risk experts Etti Baranoff et al. explained in Risk Management for Individuals and Enterprises. For example, losses stemming from a car accident include not only the cost of repairs, they noted, but may also include the cost of "time taken to get the car repaired or work hours lost in getting bids and car repairs."
- Liability pure risks are risks arising from litigation against a person or organization. For example, homeowners could be sued for medical expenses, lost income or other damages by someone who slipped on their walkway. In addition, as noted by Baranoff et al., individuals and organizations "can also be liable for loss caused by a third party (such as a child, a house guest, or an employee) who is considered at fault."
Pure risk vs. speculative risk
Whereas pure risk is beyond human control and can only result in a loss if it occurs, speculative risk is risk that is taken on voluntarily and can result in either a profit or loss. Speculative risks are thus considered controllable risks. Almost all financial investment activities, for example, are considered speculative risk because they are chosen risks and can result in loss or gain.
Betting on sports is considered a speculative, controllable risk. A person betting on a National Football League game could see either a financial gain or loss from the bet, depending on whether the team that's chosen wins or loses. Unlike pure risk, which is generally handled by insurance, speculative risk is traditionally handled by the capital markets. But, as Baranoff et al. noted, "the boundary between how these two industries manage risk is increasingly blurred, as capital market approaches expand into traditionally insurance domains, and insurance products increasingly use capital markets to hedge the pure risks they assume."
This article is part of
What is risk management and why is it important?
- Which also includes:
- governance, risk management and compliance (GRC)
- risk avoidance
- risk map (risk heat map)
Static risk vs. dynamic risk
Static risk is a type of pure risk that is predictable, measurable and doesn't change. It is a type of pure risk because it is not chosen and no financial gain can come from static risk.
Insuranceopedia, an online repository of financial information and insurance definitions, defines static risk as "risks that involve losses brought about by acts of nature or by malicious and criminal acts by another person. These losses refer to damage or loss to property or entity that is not caused by the economy." A flood is an example of static risk. According to Insuranceopedia, static risks "are more easily taken care of by insurance coverage because of their relative predictability."
Dynamic risk, in contrast to static risk, is a "risk brought on by sudden and unpredictable changes in the economy," according to Insuranceopedia. This type of risk is difficult to measure, sometimes resulting in sizable losses for individuals and businesses. Insuranceopedia pointed to the COVID-19 pandemic as an example of dynamic risk, not only due its unpredictability, but also its impact on many lines of insurance coverage, including business interruption, trade credit and cyber liability insurance. A recession is another example of a dynamic risk, as well as a fundamental risk.
More on risk management
The following articles provide resources for risk management professionals:
Risk management process: What are the 5 steps?
Implementing an enterprise risk management framework
9 common risk management failures and how to avoid them
ISO 31000 vs. COSO: Comparing risk management standards
Fundamental risk vs. particular risk
Fundamental risk is risk that affects entire societies or a large population within a society. Natural disasters, such as earthquakes and hurricanes, fall into the category of fundamental risk, as do phenomena such as inflation and war, which typically affect large numbers of people. In distinction to static risk, fundamental risk may or may not be insurable.
Particular risk, in contrast to fundamental risk, refers to risks that affect an individual, such as a fire that destroys a family home, theft of a car or robbery. Particular risk can be insured.
Pure risk insurance
Pure risks are insurable through commercial, personal or liability insurance policies. In these policies, individuals or organizations transfer part of the pure risk to the insurer. For example, home insurance policies protect against natural disasters by providing money for rebuilding. For life insurance policies, the insured makes premium payments, and the insurance company provides a lump sum payment to beneficiaries upon the insured person's death.
When a company provides insurance against a pure risk, it is engaging in speculative risk because the entity is trying to ensure that the customer will not experience a loss until the after the company has profited from the risk transfer.
Pure risks are insurable partly because the law of large numbers makes insurers capable of predicting loss figures in advance.