Pure Risk

What is pure risk?

In the most basic sense, risk is the possibility that something might happen. Pure risk is a type of risk in which there are only two possibilities: nothing happens, or something negative happens—there is no possible upside. This contrasts with speculative risk, which has the same two possibilities but also the chance of a positive outcome.

Pure risk is also known as absolute risk.

As an example of each type of risk, imagine a friend wants to open a hot dog cart. A pure risk would be loaning your friend $1,000 interest-free to buy the cart. The only possibilities are:

1. They repay your $1,000, so you suffer no loss
2. They don’t pay you back, and you’ve lost money

On the other hand, a speculative risk would be investing $1,000 in the hot dog cart in exchange for 10% of the profits. That way, the possibilities are:

1. You get back your initial $1,000, breaking even
2. The hot dog cart goes out of business before you get back your $1,000; you’ve lost money
3. The hot dog cart is successful, and you earn part of its profit on top of your initial $1,000

Pure risk (and risk in general) is an important concept in insurance—you’ll see why in the following section.

Pure risk and risk mitigation

Risk is part of life. Sometimes it’s avoidable, but most of the time, we need to learn how to live with it. Fortunately, there are practical methods for approaching risk. There are essentially four ways to deal with (or mitigate) risk:

1. Avoidance

Risk avoidance means simply choosing not to take a risk. In the hot dog cart example, it would mean neither offering a loan nor investing—rather walking away from the hot dog cart proposal entirely.

2. Reduction

Risk reduction means taking a risk, but also taking steps to reduce the impact or frequency of any potential losses. With the hot dog cart, it might mean choosing to invest in one whose owner has prior experience running food trucks, instead of one whose owner has never run a business before.

3. Acceptance

Risk acceptance is as simple as it gets: taking the risk as-is. Both the hot dog cart examples from the previous section are simple risk acceptance: either loaning the money or making the investment with no additional measures to protect the lender or investor from potential loss. Some risks are just worth it.

4. Transfer

Risk transfer is the process of offloading your risk onto another party. The most common form this takes is insurance. In exchange for a premium, an insurance company agrees to cover certain risks as laid out in the insurance policy.

Only pure risks are insurable. But as long as the insurer can calculate the risk and an appropriate premium to charge in exchange for it, pretty much any pure risk is theoretically insurable. Of course, many risks are difficult to quantify, which is why insurance policies usually exclude highly unpredictable events like war or terrorism.

Using home insurance as an example: a home insurance policy transfers the risk of the house burning down (among many other things) from the homeowner to the insurance company. The homeowner pays their premiums, and in exchange, the insurance company agrees to cover the cost of repairing the home if it’s damaged by a peril covered by the policy (like fire, hail, or wind).

Most insurance policies include deductibles—amounts that the policyholder pays when they make a claim, before their policy covers the rest of a loss. A deductible is the policyholder’s agreement to retain a small portion of the risk (and pay lower premiums in exchange).

It’s possible to buy insurance for all sorts of risks: loss or damage to your stuff, liability-related damages, vehicle accidents, business interruptions… Most insurance policies cover multiple forms of risk.

The important points

• A pure risk is a risk with no potential upside.
• There are several ways to manage risk, including avoidance, reduction, or transference.
• Risk transfer is the primary function of insurance.

Looking for another insurance definition? Look it up in The Insurance Glossary, home to dozens of easy-to-follow definitions for the most common insurance terms. Or, get an online quote in under 5 minutes and find out how affordable personalized home insurance can be.