Risk exists whenever there is uncertainty about outcome. If you knew for certain that you would become a millionaire by purchasing the stock of a particular company, there would be no risk involved in investing. Likewise, if you knew that you would never be involved in an automobile accident, you would likely not purchase insurance..
Whenever you are faced with a risk, three possible things can happen:
- Positive outcome. If you purchase a lottery ticket and win, that is considered a gain.
- Negative outcome. You could purchase a lottery ticket and not win, therefore the money you spent purchasing the ticket is considered a loss.
- Neutral outcome. There’s no loss, but there’s no gain either.
Taking a risk means not knowing exactly what will happen. Facing risks is part of life, and it is the basic problem insurance addresses.
Risk, however, comes in two forms, and insurance only addresses one of them.
Pure risk exists whenever there are only two possible outcomes: loss or no loss. This is the type of risk insurance addresses.
Your home burns (loss) or it does not (no loss). Your car is damaged in an accident (loss) or it is not (no loss).
With speculative risk there is a third possible outcome – gain. When you purchase a company’s stock, the value of the stock could decline (loss), it could stay the same (no loss), or it could appreciate (gain). When a company comes up with a new product, it could be a flop (loss), it could break even (no loss), or it could be a huge success (gain).
Insurance does not deal with speculative risk, since the potential for gain or profit would be a violation of the general principles of insurable interest and indemnity. The purpose of insurance is to protect against loss. If there is no potential for a loss to occur or if there is potential for the person to profit or gain, insurance usually cannot be purchased.
Every individual and business needs to analyze their exposure to risk, decide if they are going to buy insurance and work to minimize the hazards associated with that risk. If you worked in insurance you could help businesses like St. Augustine Alligator Farm protect people using a zip line above crocodiles.