1.4 Types of Risks—Risk Exposures

Because the financial consequences of all risk exposures are ultimately borne by people (either as individuals, stakeholders in corporations, or as taxpayers), it could be said that all exposures are personal. Some risks, however, affect individual lives more directly. Exposure to premature death, sickness, disability, unemployment, personal automobile accident, house fire, and dependent old age are examples of personal loss exposures when considered at the individual/personal level. An organization may also experience loss from these events, when such events affect employees. For example, changes in employee mortality or morbidity risk exposures could affect employer-sponsored health or pension plan costs. But these are not typically considered personal loss exposures.

Property loss exposure is associated with both real property such as buildings, and personal property such as automobiles and the contents of a building. A property is exposed to losses because of accidents or catastrophes such as floods or hurricanes. Property owners face the possibility of both direct and indirect (consequential) losses. If a car is damaged in a collision, the direct loss is the cost of repairs. The indirect losses may include time taken to get the car repaired or work hours lost in getting bids and car repairs.  If a firm experiences a fire in its warehouse, the direct cost is the cost of rebuilding and replacing inventory. Consequential or indirect losses are nonphysical losses, such as loss of income during the rebuilding process, and continuing expenses, such as the need to keep paying key employees while the business does not bring in revenue. Indirect losses also include the time and effort required to arrange for repairs, the loss of use of the warehouse during the repairs, and the additional cost of temporary facilities.

The legal system is designed to mitigate risks and is not intended to create new risks. However, the legal system also has the power to transfer risk from one party to another. Under most legal systems, one can be held responsible for the financial consequences of having caused damage to others. But an individual or organization can also be liable for loss caused by a third party (such as a child, a house guest, or an employee) who is considered at fault. The responsible party (the parent, homeowner, or the employer) may be legally obligated to pay for injury to persons or damage to property. Some examples of situations where you (or your business) could be liable for third-party losses:

Catastrophic risk exposures occur when potential losses are too large for a single entity (like an insurer or an individual corporation) to carry. Such a loss would have a substantial negative effect on a company’s operations and might even lead to insolvency.  Catastrophes involve a huge or costly loss (in terms of property damage, lives lost, destruction, etc.) which may be associated with a single event—like the September 11, 2001 terrorist attack on the twin World Trade Center towers in New York City. Catastrophes may also be the result of an accumulation of a large number of smaller losses, each of which may be absorbed individually, but whose loss is overwhelming in the aggregate. This latter type of catastrophe is usually associated with a concentration of strong, positively correlated risk exposures; for example many homes in the same location being simultaneously exposed to earthquake, flood, or hurricane windstorm damage.

A flood may damage or destroy all the homes and businesses in its path. Because a flood affects a large number of exposure units at the same time, all these exposures together represent a fundamental risk. Generally, catastrophic  risks are too large in size and geographically concentrated to be underwritten by insurers. Such catastrophes may even affect the entire economy of a geographic area where they occur.

 When too many properties in one location could be damaged at the same time, for-profit insurers decline to insure them. For an insurer, such large simultaneous losses could result in bankruptcy. This is why very few private insurers underwrite flood insurance risks. During Hurricane Harvey (August 2017) much of the property loss and damage experienced in Houston was caused by flooding, not wind damage. While some homeowners (15–20%) had flood insurance through the federal government’s National Flood Insurance Program, the majority of flooded homes and businesses were not insured against flooding. Private insurers stopped offering flood insurance in the late 1920s, following catastrophic flooding (and insured losses) along the Mississippi River. As a result, today most flood insurance in the United States is underwritten by the federal government (see Chapter 13 “Multirisk Management Contracts I: Homeowners”).

Catastrophic losses are often shared between insurers and reinsurers. A reinsurerA specialized insurance company that supplies coverage only to insurers. is a specialized insurance company that supplies coverage only to other insurers. Reinsurers can spread the risks geographically and over time.

Fundamental risks Risk which affects many or most of the properties (or individuals, or businesses) in a geographic area and is non-diversifiable. May be caused by a natural catastrophe, economic downturn, or other event affecting a large part of the population (opposite of particular risk)., like catastrophic risks, generally affect many or most of the properties (or individuals, or businesses) in a geographic area and are non-diversifiable. This type of risk is broader than catastrophic risk, however, because it includes more than just physical catastrophes, but can also include an economic downturn or other event affecting a large part of the population.

An economic downturn can also result in systemic risk, if the interconnectedness of the affected institutions triggers a cascade effect. Systemic risk Risks from interconnected causes of loss, producing a domino effect in which the failure of one large institution  causes the next failure, leading to the next, and so on, until the entire economy is negatively affected. is a term which came into widespread usage following the financial crisis of 2008, when the linkages between banks played a large part in the credit crisis and the economic downturn. The G-20 asked the Financial Stability Board (FSB) to define systemic risk and develop models to avoid similar crises in the future. The definition, in general, refers to the domino effect that occurs when one financial institution’s failure has a negative effect on other financial institutions and on the economy as a whole. The large size of financial institutions and their close links to each other amplified the effect in 2008. Because of this interconnectedness, systemic risk can be considered even broader than fundamental risk, and can easily become a global risk, affecting multiple countries.

Many pure risks are the result of accidental, unintentional causes of loss.  As opposed to fundamental losses, which tend to affect a larger area, non-catastrophic accidental losses, such as those caused by individual fires, are considered particular Risk that is specifically affected by a certain cause of loss (opposite to fundamental risk). or idiosyncratic risksRisk with individual characteristics, not shared by all. Considered amenable to mitigation through insurance or capital market securitization.  . Often, when the potential losses are reasonably bounded in size or geographic spread, a risk-transfer mechanism, such as insurance or capital market securitization can be used to handle (spread) the financial consequences of the potential loss so that the risk realization does not severely devastate the original risk holder.