Which of the following is any situation that represents the possibility of a loss?

What Is Pure Risk?

Pure risk is a category of risk that cannot be controlled and has two outcomes: complete loss or no loss at all. There are no opportunities for gain or profit when pure risk is involved.

Pure risk is generally prevalent in situations such as natural disasters, fires, or death. These situations cannot be predicted and are beyond anyone's control. Pure risk is also referred to as absolute risk.

Key Takeaways

• Pure risk cannot be controlled and has two outcomes: complete loss or no loss at all.
• There are no opportunities for gain or profit when pure risk is involved.
• Pure risks can be divided into three different categories: personal, property, and liability.
• Many cases of pure risk are insurable.

Understanding Pure Risk

There are no measurable benefits when it comes to pure risk. Instead, there are two possibilities. On the one hand, there is a chance that nothing will happen or no loss at all. On the other, there may be the likelihood of total loss.

Pure risks can be divided into three different categories: personal, property, and liability. There are four ways to mitigate pure risk: reduction, avoidance, acceptance, and transference. The most common method of dealing with pure risk is to transfer it to an insurance company by purchasing an insurance policy.

Many instances of pure risk are insurable. For example, an insurance company insures a policyholder's automobile against theft. If the car is stolen, the insurance company has to bear a loss. However, if it isn't stolen, the company doesn't make any gain. Pure risk stands in direct contrast to speculative risk, which investors make a conscious choice to participate in and can result in a loss or gain.

Pure risks can be insured because insurers are able to predict what their losses may be.

Types of Pure Risk

Personal risks directly affect an individual and may involve the loss of earnings and assets or an increase in expenses. For example, unemployment may create financial burdens from the loss of income and employment benefits. Identity theft may result in damaged credit, and poor health may result in substantial medical bills, as well as the loss of earning power and the depletion of savings.

Property risks involve property damaged due to uncontrollable forces such as fire, lightning, hurricanes, tornados, or hail.

Liability risks may involve litigation due to real or perceived injustice. For example, a person injured after slipping on someone else's icy driveway may sue for medical expenses, lost income, and other associated damages.

Insuring Against Pure Risk

Unlike most speculative risks, pure risks are typically insurable through commercial, personal, or liability insurance policies. Individuals transfer part of a pure risk to an insurer. For example, homeowners purchase home insurance to protect against perils that cause damage or loss. The insurer now shares the potential risk with the homeowner.

Pure risks are insurable partly because the law of large numbers applies more readily than to speculative risks. Insurers are more capable of predicting loss figures in advance and will not extend themselves into a market if they see it as unprofitable.

Speculative Risk

Unlike pure risk, speculative risk has opportunities for loss or gain and requires the consideration of all potential risks before choosing an action. For example, investors purchase securities believing they will increase in value.

But the opportunity for loss is always present. Businesses venture into new markets, purchase new equipment, and diversify existing product lines because they recognize the potential gain surpasses the potential loss.

Most insurance providers only cover pure risks, or those risks that embody most or all of the main elements of insurable risk. These elements are "due to chance," definiteness and measurability, statistical predictability, lack of catastrophic exposure, random selection, and large loss exposure.

Pure Risk vs. Speculative Risk

Insurance companies normally only indemnify against pure risks, otherwise known as event risks. A pure risk includes any uncertain situation where the opportunity for loss is present and the opportunity for financial gain is absent.

Speculative risks are those that might produce a profit or loss, namely business ventures or gambling transactions. Speculative risks lack the core elements of insurability and are almost never insured.

Key Takeaways

• Speculative risks are almost never insured by insurance companies, unlike pure risks.
• Insurance companies require policyholders to submit proof of loss (often via bills) before they will agree to pay for damages. 
• Losses that occur more frequently or have a higher required benefit normally have a higher premium.

Examples of pure risks include natural events, such as fires or floods, or other accidents, such as an automobile crash or an athlete seriously injuring his or her knee. Most pure risks can be divided into three categories: personal risks that affect the income-earning power of the insured person, property risks, and liability risks that cover losses resulting from social interactions. Not all pure risks are covered by private insurers.

Due to Chance

An insurable risk must have the prospect of accidental loss, meaning that the loss must be the result of an unintended action and must be unexpected in its exact timing and impact.

The insurance industry normally refers to this as "due to chance." Insurers only pay out claims for loss events brought about through accidental means, though this definition may vary from state to state. It protects against intentional acts of loss, such as a landlord burning down his or her own building.

Definiteness and Measurability

For a loss to be covered, the policyholder must be able to demonstrate a definite proof of loss, normally in the form of bills in a measurable amount. If the extent of the loss cannot be calculated or cannot be fully identified, then it is not insured. Without this information, an insurance company can neither produce a reasonable benefit amount or premium cost.

For an insurance company, catastrophic risk is simply any severe loss deemed too expensive, pervasive, or unpredictable for the insurance company to reasonably cover.

Statistically Predictable

Insurance is a game of statistics, and insurance providers must be able to estimate how often a loss might occur and the severity of the loss. Life and health insurance providers, for example, rely on actuarial science and mortality and morbidity tables to project losses across populations.

Not Catastrophic

Standard insurance does not guard against catastrophic perils. It might be surprising to see an exclusion against catastrophes listed among the core elements of an insurable risk, but it makes sense given the insurance industry's definition of catastrophic, often abbreviated as "cat."

There are two kinds of catastrophic risk. The first is present whenever all or many units within a risk group, such as the policyholders in that class of insurance, are all be exposed to the same event. Examples of this kind of catastrophic risk include nuclear fallout, hurricanes, or earthquakes.

The second kind of catastrophic risk involves any unpredictably large loss of value not anticipated by either the insurer or the policyholder. Perhaps the most infamous example of this kind of catastrophic event occurred during the terrorist attacks on Sept. 11, 2001.

Some insurance companies specialize in catastrophic insurance, and many insurance companies enter into reinsurance agreements to guard against catastrophic events. Investors can even purchase risk-linked securities, called "cat bonds," which raise money for catastrophic risk transfers.

Randomly Selected and Large Loss Exposure

All insurance schemes operate based on the law of large numbers. This law states there must be a sufficient large number of homogeneous exposures to any specific event in order to make a reasonable prediction about the loss related to an event.

A second related rule is that the number of exposure units, or policyholders, must also be large enough to encompass a statistically random sample of the overall population. This is designed to prevent insurance companies from only spreading risk among those most likely to generate a claim, as might occur under adverse selection.

The Bottom Line

There are other less significant or more obvious elements of an insurable risk. For example, the risk must result in economic hardship. Why? Because if it does not, then there is no reason to insure against the loss. The risk needs to be commonly understood between each party, which is also one of the basic elements of a valid contract in the United States.

Which of the following is a situation represents the possibility of a loss?

Which of the following is a situation where is possibility of either a loss or gain?

What is the possibility of financial loss called?

Which of the following refers to a condition that may increase the chance of a loss?