If you look at news in any way, you understand that the world is risky. Take a look at these stories in Insurance Journal.
Worker in New Jersey Seriously Injured When Ditch Collapses Around Him
Two Women Killed After New Jersey Transit Train, Car Collide at Crossing
22 Killed in Alabama Traffic Accidents Over Holidays
These are just a few stories in Insurance Journal. That doesn’t include the international news that there are real troubles in the Middle East and whatever may be going on in your community or state.
Life is risky and we understand risk sometimes in a visceral way. Some risks make us react physically. Some people get car sick due in part to their fears and concerns about riding in the car. Just the thought of walking close to a cliff makes some people dizzy and sick. Risk is often felt before it is thought about.
What is risk?
Since we feel like we understand it, let’s see if we can come up with a reasonable definition of risk that’ll work for us long term.
The first point we have to come to grips with is that the word risk means many different things to many different people in every situation. Underwriters talk about risks, but what they mean is the applicant for insurance that they just received, or the subject of the insurance policies that they just issued.
So, what do we really mean when we use the work risk? I pulled a few books off my shelf to define the term risk.
“Uncertainty that may be either positive of negative arising from a given set of circumstances.”
“Uncertainty as to the outcome of an event when two or more possibilities exist.”
“Uncertainty arising from the possible occurrence of given events.”
Do you see the common thread?
That’s what makes us feel risk. We aren’t sure what’s going to happen next. The person who fears flying is not sure if that metal noisemaker is going to get where it’s supposed to go. The person who isn’t sure which business decision to make isn’t sure because of what might happen.
In short, the essence of risk is uncertainty.
It brings with it the idea of possibility. When there’s a risk, there are multiple possibilities. When there is only one truly possible outcome, there is no risk, there is only fate. Let’s face it. There are only a very few situations where the outcome is completely known and settled well in advance. Most decisions, actions, and areas of like include risk.
Let’s break these risks down a little.
What is a speculative risk?
A speculative risk brings uncertainty about three possible outcomes. The event could bring a gain, a loss, or a wash. A wash is neither a gain nor a loss. I’ll concede that the possibility of the risk being a wash is often the least likely, but it’s still possible, so I mention it. Also, since it’s the least likely, we won’t explore it any further.
Consider two speculative risks that you are aware of every day, the lottery and the business you’re in.
With the lottery, it’s really simple. When you buy a lottery ticket, you might win, you might get your money back, and you might lose. You’ve lost when you scratch the ticket, or the numbers are drawn, and your numbers didn’t win for you and the scratch off didn’t scratch the right results. What have you lost? The money you put in, unless you go back and put some more in.
The possibility exists that the ticket you get returns you exactly what you paid for it. That’s a real wash. The problem isn’t that it’s a wash, it’s that you consider the money gone anyway and redeem the winnings for another ticket, which ends up losing anyway. So, in the end it’s a loss.
There is also the chance that you win the big money. Whether you’re thinking about the $10,000 from the scratch off of the $1 billion from the mega millions, winning is winning. Leaving aside any further comment on the odds and what often happens when someone wins big with the lottery, we will say that the risk is only financial, and a win is a win.
The other major speculative risk is in your business. Unlike what some have told us in the past, failure is always an option. It may not be the option that we want, or that we accept, but it is an option.
Every business faces speculative risks, whether it’s the launch of a product that might not be profitable, a new hire that may or may not work out, or the investment in resources that might help move the company forward. Everything in a business is a speculative risk. They all point to the possibility of gain or loss.
The nature of these speculative risks makes them uninsurable, but not unmanageable.
When you consider a speculative risk (leaving aside the lottery and only considering business), and the outcomes, you have to conclude that insurance is not an option to hedge against the possibility of loss. It’s just not the appropriate risk financing tool for business risk.
The goal of a business is to serve as many customers as possible the best way possible in order that the customers reward the business with small pieces of paper with images of former presidents on them. For those who are digitally native, that’s cash, which is what we used before we all had debit cards.
You can say it however you want, but in the end, that’s what you want. You want to serve enough customers to make your business profitable so that you, your family, and your team continue to eat.
It would be impractical to attempt to underwriter, price, and produce a policy that truly protects against unprofitability. There are too many unknowns. What should the profit be? How do you know that? What are the variables that can impact profitability? Which of those cannot be controlled? Which might be controllable? What don’t we know?
I know that there is insurance for business income, but that’s not the same as trying to insure for profitability. Business income only provides coverage up to the provable income of the business, not the potential profit. The business owner can promise anything she wants that this year, they really were going to have $300,000 in revenue next month, but if they’ve never done that before, she’s going to have a hard time getting that $300,000 check from her insurance company (even if she did have a covered loss of business income that large).
How can you manage a speculative risk? That’s too big a topic for right now, but perhaps we’ll get into that in another post.