What it means
In everyday business, some risks can turn out well or badly, such as launching a new product that may succeed or fail. Pure risk is different, because the best outcome is simply that nothing bad happens.
If your warehouse does not burn down this year, you have not gained anything; you have just avoided a loss. This distinction matters because it decides how the risk is managed.
Pure risks are generally insurable, since insurers can pool many similar risks and predict how many losses will occur. Speculative risks, where a gain is possible, such as investing in shares, are usually not insurable in the same way.
Businesses face a wide range of pure risks. Examples include property damage, liability claims from customers or employees, cyber attacks, theft, business interruption and the death or illness of a key person.
Each can cause a financial loss with no corresponding opportunity for profit. Risk managers have several options for dealing with pure risk.
They can avoid it, reduce its likelihood or impact, transfer it to an insurer, or accept it and set money aside. The choice usually depends on how likely the event is, how large the loss could be, and how much the insurance costs.
Insurers set premiums by estimating the expected loss and adding a margin for costs and profit. A business can therefore compare the premium with its own estimate of the expected loss.
Where the premium is far above the expected loss and the company can easily absorb the hit, it may choose a higher deductible (the amount it pays before the insurer pays) to cut the cost. A common nuance is that the same event can be pure or speculative depending on the context.
A fall in the price of a commodity is a pure risk for someone who must buy it but a speculative one for a trader who can profit either way. Classifying the risk correctly helps you choose the right tool.
In practice
Real-world examples.
Example
A restaurant owner buys property insurance against fire and flooding. If neither happens, the restaurant has gained nothing from the policy except peace of mind. If a kitchen fire occurs, the insurance pays for repairs and lost trading, which turns a potentially fatal loss into a manageable one.
Example
A logistics company worries about vehicle accidents. It installs driver monitoring equipment to reduce the chance of crashes and buys liability insurance to cover the remainder. The two steps together address both the likelihood and the impact of the risk.
Example
A consulting firm depends heavily on one senior partner. It takes out key person insurance so that if the partner dies or becomes seriously ill, a lump sum is paid to the firm to cover recruitment and lost income.
Formula
Calculation
Expected loss = probability of the event x size of the loss
Suppose a workshop faces a 2% chance in any year of a fire that would cause $500,000 of uninsured damage. Expected loss = 0.02 x 500,000 = $10,000 per year. If an insurer offers cover for an annual premium of $13,000, the extra $3,000 over the expected loss pays for the insurer's costs and margin, and also buys certainty. The owner may decide that avoiding a possible $500,000 hit is worth that cost.Case study
Seen in the real world.
Calloway Plastics is an illustrative, fictional factory with a single production site worth about $8,000,000. The owner thought the chance of a major fire was so low that insurance was an unnecessary expense and cancelled the policy to save $40,000 a year.
A fault in an electrical panel caused a fire that destroyed a third of the plant and halted production for four months. The uninsured damage and lost sales came to roughly $3,000,000, far more than the savings from cancelling cover. The company survived only by selling equipment and taking on expensive debt.
The illustrative lesson was that pure risks carry no upside, so the only question is how to limit the damage. After recovering, the owner reinstated the cover and also added sprinklers, which reduced the premium.
Watch out
Common mistakes.
- Assuming a low probability means a risk can be ignored, when the size of the possible loss may still threaten the whole business.
- Treating all risks as insurable, when speculative risks such as market moves or new product launches normally cannot be insured.
- Buying insurance without comparing the premium to the likely loss and the company's ability to absorb it.
Questions
People also ask.
What is the difference between pure risk and speculative risk?
Pure risk can only produce a loss or no loss, while speculative risk can produce a gain, a loss or no change.
Is pure risk always insurable?
Not always, because insurers need losses to be measurable, accidental and reasonably predictable across many similar cases.
How do businesses manage pure risk?
They typically avoid it, reduce it through safety measures, transfer it with insurance, or retain it by setting funds aside for small losses.
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