Economic basis of insurance: meaning of risk
Risk does not necessarily equal uncertainty. If bullets are added to a revolver used for Russian roulette the uncertainty is reduced but the risk increases. Vaughan (GIM1090) gives the following definition:
‘Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for.’
For a risk to be insurable it does not need to be measurable, but it does need to be related to a measurable financial loss, or to a valued loss. This means a loss on which a value has been placed. For example, an accident insurance policy may value the loss of a limb at £10,000. Degree of risk should be distinguished from magnitude of risk. Degree of risk is the probability of the adverse event occurring, whereas magnitude of risk is the amount of the likely loss. In mathematical terms the probability of a loss of £1,000 does not necessarily reflect a greater degree of risk than the probability of a loss of £10.
Risk can be distinguished from peril, which is the actual or potential cause of loss (for example hail or fire); in practice, though, the term risk is often loosely used instead of peril. Risk and peril can both be distinguished from hazard, which is a condition that may create, decrease or increase the chance of a loss arising from a given peril (for example driving when visibility is poor as opposed to good). Insurers may also refer to ‘moral hazard’ which is where the policyholder, either intentionally or through carelessness, adds to the risks assumed by the insurer because they expect to be covered. For example a person covered by sickness insurance may prefer not to return to work even though fit to do so.