Risk
The condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for. 1
I was told a story once by a professor:
So my wife and I are coming back from a Hawkeye game, and we stop to get gas. We'd left early to beat the traffic, and in the car she kept saying "You know, the Hawkeyes were doing pretty well, I think they'll win." So I'm inside paying for the gas, and I hear on the radio that the Hawkeyes lost. So I go back out to the car and offered my wife a wager. I gave her really good odds. Of course, when she found out...
So was there a risk in the situation there?
We all said yes, thinking that she didn't know, so she was taking a risk. And he asked us, "Well, was there risk in what I was doing? Then how is it any different for her?" There was no risk; the outcome was certain. His wife was a victim of
uncertainty, doubt caused by lack of knowledge about the future, and not risk. The lesson there is that risk occurs whether we know about it or not.
There are two types of risk, and they are a world apart.
- Speculative risk is a risk with a possibility of gain or loss. In other words, you either win or lose.
- Example: I put a quarter in a slot machine (buy tech stock, whatever). I pull the handle. Now there is a risk; I either win some random amount of money or I lose my quarter.
- Pure risk merely involves the possibility of a loss. You lose or you don't lose, you never win anything.
- Example: You buy a house. There is now a risk that your house will burn, and that risk is permanent (never goes away). If your house doesn't burn, you don't win another house; you simply don't lose the house you bought.
The only risk which is
insurable (or ought to be, anyway) is a pure risk. Purchasing insurance, then,
transfers the risk to the insurer (it never goes away entirely). Speculative risks are simply
investments or
gambles.
A sensible question to ask, then, may be "Well, then if insurance companies are accepting other people's risks, how do they make money?" The answer is in the insurance company's ability to predict losses over a large number of
exposures, or risks. If a company only insures 10 homes against total loss by fire, for example, and they predict 1 loss (10%), there's a good chance they will have exactly 1 loss. But what if no houses burn? Huge profits. What if they have 2? The company would probably take a loss. Now imagine that the company insures 1000 homes against total loss by fire. They still predict 10% loss, which now equals 100 homes. A deviation of one home, or even 10 homes, above or below the prediction means far less to the company than it did when they were only covering 10 exposures. The point to transferring your risk to a professional risk bearer is that they are better equipped to deal with your risk; they pool thousands, even millions of risks, minimizing impact of losses and even making money in the process.
In a corporation, a
risk manager is a person either hired or contracted by a company to manage that company's risks. This person's function is to use any tools at his/her disposal to ensure that the company can continue to function as intended. They develop processes to either avoid risks altogether, minimize their chance of occurring, or minimize the financial impact of those losses that do occur (by purchasing
insurance).
1Taken from Vaughan and Vaughan,
Essentials of Risk Management, second ed.