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Risk, exposure, hazard, peril, and loss, and the methods of handling risk

Lesson 9 of 105 · All lessons · Up next: Elements of insurable risk, adverse selection, the law of large numbers, and reinsurance →

Why these words matter

Every insurance contract is built on a small vocabulary: risk, exposure, hazard, peril and loss. Exam questions often turn on telling them apart, so learn each one as a separate idea and then see how they fit into one chain.

Risk

Risk is uncertainty about whether a loss will happen. If a loss is certain, it is not a risk. It is a cost. Insurance deals with uncertainty, so it can only cover risk.

Risk comes in two kinds:

  • Pure risk has only two possible outcomes: a loss, or no loss. A house either burns or it does not. Nobody gains from the event. Only pure risk is insurable.
  • Speculative risk has three possible outcomes: loss, no loss, or gain. Gambling, buying stock and starting a business are speculative. Insurance does not cover speculative risk, because insurance is meant to restore you, not to let you profit.

Exposure

Exposure is the state of being open to loss, and it is also the unit used to measure that openness. A fleet of 50 trucks has more exposure than one truck. A payroll of $5 million has more workers' compensation exposure than a payroll of $500,000. Insurers count exposure units to predict how many losses to expect and to price the coverage.

Peril

A peril is the cause of a loss. Fire, windstorm, theft, collision, illness and death are perils. When a policy lists what it covers, it is usually listing perils.

Hazard

A hazard is a condition that increases the chance that a peril will strike, or makes the loss worse when it does. A hazard is not the cause itself. There are three hazards you must know:

  • Physical hazard: a tangible condition of a person or property. Examples are oily rags in a garage, icy steps, faulty wiring, or a history of heart disease.
  • Moral hazard: dishonesty or bad character that makes a loss more likely. An insured who would set a fire to collect on the policy, or who inflates a claim, is a moral hazard.
  • Morale hazard: carelessness or indifference because insurance exists. "It's insured, so why lock the car?" is morale hazard. There is no intent to defraud, only a lack of care.

Memory hook: moral is about morals, meaning dishonesty. Morale is about attitude, meaning carelessness.

Some texts also name a legal hazard: court rulings or laws that tend to increase the size of claims.

Loss

A loss is an unintended, unexpected reduction in value. It is what the policy pays for. A direct loss is the immediate physical damage, such as the burned building. An indirect or consequential loss follows from it, such as lost rent or the extra cost of living elsewhere while the building is repaired.

Putting the chain together

A diagram in two rows under the heading: Risk, uncertainty about whether a loss will happen. The top row is a chain of four boxes joined by arrows, left to right. First, Exposure: being open to loss, for example a three hundred thousand dollar house. An arrow leads to Hazard: a condition that raises the chance of loss, of three kinds, physical, moral and morale. An arrow leads to Peril: the cause, for example fire. An arrow leads to Loss: a reduction in value, either direct or indirect. The bottom row, titled Five methods of handling risk, shows five boxes. Avoid: skip the activity, so no pool means no pool liability. Reduce: lower the chance or size of a loss, for example smoke detectors. Retain: pay the loss yourself, through a deductible or self-insurance. Share: spread a loss across a group, as in a partnership. Transfer, highlighted in green: shift the cost to another party by buying insurance. A note at the bottom says only pure risk, loss or no loss, is insurable, while speculative risk adds a chance of gain.
Exposure, hazard, peril and loss form a chain; five methods handle the risk.

Picture a home with faulty wiring. The exposure is the house itself, valued at $300,000. The faulty wiring is a physical hazard. Fire is the peril. The burned kitchen is the direct loss, and the hotel bill while it is rebuilt is an indirect loss. The risk is the uncertainty over whether any of this will happen.

The methods of handling risk

There are five ways to handle a risk. The exam expects you to recognize each one from a short scenario.

  1. Avoidance: eliminate the risk by not doing the activity. If you never own a swimming pool, you face no pool liability. Avoidance is the only method that removes the risk completely, but it often is not practical.
  2. Reduction (loss control): lower the chance of a loss or the size of a loss without removing it. Smoke detectors, sprinklers, burglar alarms, safety training and annual physicals are all reduction.
  3. Retention: accept the risk and pay any loss yourself. Retention can be planned, as with a deductible or self-insurance, or unplanned, when you simply did not know about the risk. Retention makes sense for small, predictable losses.
  4. Sharing: spread a loss across a group, so that each member bears part of it. Partnerships and mutual arrangements share risk. Insurance itself rests on sharing: many people each pay a premium so that the few who suffer a loss can be paid.
  5. Transfer: shift the financial consequence of a loss to another party. Buying insurance is the classic transfer. In return for a premium, the insurer takes on the financial burden of covered losses. Hold-harmless clauses in contracts are also transfer.

How an insurer prices what it takes on

When an insurer accepts a transferred risk, it charges a premium that reflects its expectation of loss, its expenses and its profit. It also classifies applicants by their risk characteristics. In life insurance, an applicant who fits the normal standards is a standard risk. An applicant with impaired health or a dangerous job, which are both hazards, may be a substandard risk and pay an extra charge.

Choosing a method

A useful rule of thumb pairs frequency with severity:

  • High frequency, high severity: avoid.
  • High frequency, low severity: reduce and retain.
  • Low frequency, high severity: transfer, which means insure.
  • Low frequency, low severity: retain.

This is why insurance is best suited to losses that are unlikely to happen but would be financially devastating if they did.

Key terms

Sample questions

In insurance, what does the term "risk" mean?

  • The cause of a loss, such as fire or theft
  • A condition that makes a loss more likely to happen
  • Uncertainty about whether a loss will occur
  • The unintended reduction in the value of property
Reveal answer

Correct answer: Uncertainty about whether a loss will occur

Risk is uncertainty concerning loss. Where a loss is certain there is no risk, only a cost, so insurance deals with the uncertainty of whether a loss will happen.

Which situation involves a pure risk?

  • An investor buys shares that may rise or fall in value
  • A gambler bets on the outcome of a horse race
  • An entrepreneur opens a restaurant that may turn a profit
  • A homeowner may or may not suffer damage from a kitchen fire
Reveal answer

Correct answer: A homeowner may or may not suffer damage from a kitchen fire

Pure risk has only two outcomes: loss or no loss. A house fire either happens or it does not, and the owner cannot profit from it. The other choices all carry a chance of gain, which makes them speculative.

Which term describes the state of being open to possible loss, measured in units such as vehicles, payroll or property value?

  • Hazard
  • Peril
  • Exposure
  • Indemnity
Reveal answer

Correct answer: Exposure

Exposure is the state of being subject to loss, and insurers express it in exposure units, such as the number of vehicles, the size of a payroll or the value of a building, to predict and price losses.

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See where this fits: New York exam outline and topic weights.