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 risk, avoid risk, accept it or transfer it. Insurance can be purchased to cover potential loss from many types of pure risk. This approach transfers the risk to an insurance company.
The key concepts of pure risk
Pure risk is an important concept in risk management. Key characteristics of pure risk include the following:
- Uncontrollable nature. Pure risks come from situations beyond anyone's control, such as natural disasters, fires and accidental death.
- Binary outcome. Pure risk results in either a loss or no loss, but never a financial or other type of gain.
- Unavoidable exposure. Most organizations and individuals face some sort of pure risk in their business or life.
- Insurable. Pure risks are typically insurable through liability, commercial or personal insurance policies, letting individuals and businesses transfer the financial burden to an insurer.
- Risk management and mitigation. Companies and individuals who understand the pure risks they face can develop preemptive controls and processes, as well as mitigation strategies, to minimize potential losses.
- Business continuity. Attention to pure risks is essential to minimize issues stemming from those risks and maintain operations during unexpected events.
What are examples of pure risk?
Pure risk, also referred to as absolute risk, is divided into three categories:
- Personal pure risks. These 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, reducing personal assets, is another example. Other types of personal pure risks include house fires, disability and premature death.
- Property pure risks. These 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, they note that losses stemming from a car accident can include not only the cost of repairs, but also the cost of "time taken to get the car repaired or work hours lost in getting bids and car repairs."
- Liability pure risks. These are risks arising from litigation against a person or organization. For example, someone slipping on a private home walkway can sue the homeowner for medical expenses, lost income or other damages. Baranoff et al. note that 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
Pure risk is beyond human control and can only result in a loss if it occurs. Speculative risk is risk that's taken on voluntarily and can result in either a profit or loss. Speculative risks are considered controllable risks. For example, almost all financial investment activities are considered speculative risks 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 an NFL game could see either a financial gain or loss from the bet, depending on whether the team they choose 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."
Static risk vs. dynamic risk
Static and dynamic risk are two types of pure risks that are distinguished by predictability.
Static risk
Static risk is a type of pure risk that is predictable and measurable and doesn't change. It's a type of pure risk because it isn't chosen, and no financial gain can come from static risk.
Insuranceopedia, an online repository of financial information and insurance definitions, defines static risk as risk related to losses brought about by acts of nature, such as a flood, or by malicious and criminal acts of a person. This type of risk is related to damage or losses that aren't caused by economic factors. Because of static risk's relative predictability, insurance is generally used to hedge against it.
Dynamic risk
Dynamic risk is a type of risk related to 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.
The COVID-19 pandemic is an example of dynamic risk because of its unpredictability and its effect 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:
Top steps in the risk management process
ERM implementation: How to deploy a framework and program
Common risk management failures and how to avoid them
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 fundamental risk category, as do inflation and war, both of which affect large numbers of people. Fundamental risk might or might not be insurable.
Particular risk refers to risks that affect an individual, such as a fire that destroys a family home, the theft of a car or a robbery. Particular risk can be insured.
Pure risk insurance
Many 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's engaging in speculative risk because it's trying to make sure that the customer won't experience a loss until after the company has profited from the risk transfer. Pure risks are often insurable partly because the law of large numbers makes insurers capable of predicting loss figures in advance.
