 Personal finance PowerPoint presentation, risk terminology. Get ready to get financially fit by practicing personal finance. When thinking about our personal insurance strategy, our goal is to lower or mitigate risk, which can be difficult because risk represents something that's gonna happen into the future. No one has a crystal ball. We don't know what's going to happen in the future, but we would like to get an idea of what risk is and then how we can measure risk as best we can so we can use our tool of insurance to help us to mitigate risk. So risk is the chance of loss or injury. Now that means, of course, loss or injury that could happen into the future. That's what chance is implying here because if I was injured at this point in time, there's no chance that would be after the fact at this point in time. So we're talking about possible loss or injury into the future. Now, if the probability of that loss or injury goes up or is high, then we would like to have some kind of coverage to help us out with that and or if it's not likely that it's gonna happen, but it could possibly happen. And if it were to happen, it would be a catastrophe for us possibly financially. Then even though it's not likely to happen, we might want to insure against it. So because of the extreme level that it could have, if it was to occur, for example, so that's another area where we might have to be insurance and note, we have to kind of balance those things out. How likely is something to happen and then how much of a catastrophe would it be if it were to happen to try to get a plan about the insurance without getting too completely paranoid about thinking about the future and all this stuff. So uncertainty or lack of predictability. So clearly when we're thinking about risk, there's a risk because we don't know. We're talking about something that's gonna happen in the future or may happen into the future. So all we can think about is probability or likelihood of a possibility. Peril, anything that may cause loss. So that's gonna be fire, windstorm, robbery, accidents. Hazard, anything that increases the likelihood of loss. So when we think about the term peril, we're thinking about the actual item, the firestorm, the windstorm, the robbery and so on. And if we think about a hazard, then if we're going into an area where it's more likely that there's gonna be robbery, those are gonna be more hazardous kind of situations. For example, driving drunk or a defective wiring could be a hazard. So clearly driving drunk is a hazard because it's gonna increase the possibility of the car accident, defective wiring is a hazard because it could increase the cause of a fire. Most common types of risk. So we're gonna put the risk into our categories of the personal risk which could include loss of income or life caused by illness, old age or unemployment, property risk, loss of property, caused by perils like fire or theft, a liability risk, losses caused by negligence, resulting in injury or property damage. So these are just the categories that we can put the risk into. Now note when we think in terms of insurance, how can we use insurance to help mitigate these risks? They can't really compensate us for some of the things that would be involved here. Obviously insurance if you had a claim can only compensate someone with basically money with some kind of tangible value at that point in time. So for example, if there was a loss of income, then some kind of insurance if insurance was to cover that loss could then replace some of the money which would be good but if there's a loss of life then clearly the insurance is not going to replace the loss of life but it might be able to replace some of the income streams and so on and so forth with regards to that loss of life. So clearly we can't use insurance to mitigate in other words all risks in life and when there is gonna be compensation from the insurance in order to compensate for the loss because we have some insurance against it, it has to be in some kind of tangible terms which is gonna be generally money kind of compensation. So obviously again if we had like an illness or something like that and we got sick and it was covered, the insurance isn't going to stop us from getting sick, right? We might want to do our own kind of medication to prevent that from happening but it might help us to give us the money to deal with the treatments when sick and so on same with the property. You might say well there's nothing that can replace that house and all the memorabilia that was in the house and so on and so forth and that's true. So obviously we want to try to prevent a property from burning down or something like that. Take cautions that other personal cautions to prevent things from happening but if it was insured then we might be able to get some financial compensation, some money to replace the loss of the properties. We then have the concepts of pure risk and speculative risk which we'll talk more about shortly but for now just note that the pure risk is typically the type that is insurable whereas the speculative risk is generally not. When we're talking about pure risk we're talking about types of things that either don't happen and you're okay or they do happen and you have loss so you really only have downside if an event happens. So if there's a fire that burns something down either the fire doesn't happen or it does happen if it does happen you typically don't have a gain you're gonna have a loss at that point in time whereas speculative risk means that you could have a gain or loss such as going into business for yourself. You might have income, you might have a gain or you might have a loss or for example gambling. Let's talk a little bit more detail about pure risk. You can find this at Investopedia. Take a look at the references and resources online. This is by Julia Kagan, updated May 10th, 2021. What is pure risk? Pure risk is a category of risk that cannot be controlled and has two outcomes complete loss or no loss at all. So that's what the pure risk is. That's the types of things that we might have insurance against. Either something happens and you have a loss or nothing happens and there's no loss as opposed to something happening and you get a gain from out of the situation. So there are no opportunities for gain or profit when pure risk is involved. Pure risk is generally prevalent in situations such as natural disaster, fires or death. So clearly if you have a house and a fire happens not in the fireplace that might be a gain but the whole place burns down then there's no gain involved there. You might get recompensated by the insurance and so on but generally the insurance is based on the fact that it's a pure risk. Death clearly when death happens there's only loss at the point of death. So it either doesn't happen at this point in time or there's a loss that happens. So these situations cannot be predicted and are beyond anyone's control. I can control, maybe not. Pure risk is also referred to as absolute risk, understanding pure risk. There are no measurable benefits when it comes to pure risks. Instead, there are two possibilities. On the one hand, there is a chance that nothing will happen or no loss at all. So if nothing happens, then that's the good outcome. If something doesn't burn down your house then that's better than it burning down. On the other hand, there may be the likelihood of total loss. So if the fire does burn down the house if there's a wildfire and the house burns down, total loss. Pure risk can be divided into three different categories personal, property and liability. There are four ways to mitigate pure risk, reduction, avoidance, acceptance and transference. The most common method of dealing with pure risk is to transfer it to an insurance company by purchasing an insurance policy. So obviously if you're in a place it's gonna have wildfires. Again, you gotta kind of measure the pros and cons of this. If you're in a place that has absolutely no likelihood of a wildfire you live in a place that rains every other day or something like that. Then you probably don't need the fire insurance even though if the fire actually did happen and burned down the home it would be a catastrophe type of event. But if you're in a place where it's not likely that your house is gonna burn down but you're in a place where wildfires do happen so there is a likelihood of it happening and if it were to happen, it's a high probability it's gonna be a catastrophe type of event financially then you would think the insurance would be more likely something that you would want. So any instance of pure risk are insurable. For example, an insurance company ensures a policy holder's automobile against theft. If the car is stolen the insurance company has to bear a loss. So clearly you don't want your car to be stolen. If someone steals your car there's only downside to it. The likelihood of it happening is low but if it does happen it could be a substantial event given the value of the car, the cost of the car and therefore insurance might be appropriate in that situation. However, if it isn't stolen the company doesn't make any gain. Pure risk stands in direct contracts to speculative risk which investors make a conscious choice to participate in and can result in a loss or a gain. That would be things like gambling or starting a business. So that way there could be a loss there's still risk that there's a loss that could happen but it's not a pure risk because you could have a gain there hopefully and that's what you're hoping for. Types of pure risk. Personal risk directly affected an individual and may involve the loss of earnings and assets or an increase in expenses. For example, unemployment may create financial burdens from the loss of income and employment benefits. So identified theft, identity theft may result in damaged credits or poor health may result in substantial medical bills as well as the loss of earnings power and the depletion of savings. Property risk involves property damage due to uncontrollable forces such as fire, lightning, hurricanes, tornadoes or hail. The hail's no good. Liability risks may involve litigation due to real or perceived injustices. For example, a person injured after slipping on someone else's icy driveway may sue the medical expenses, lost income or other associated damages. So if any of those things happened, then obviously you have a loss that would be happening. If they didn't happen, then you would typically be better off and therefore those are things that are somewhat predictable. You can put some stats into the future and so on with them and possibly could be insurable. Ensuring against pure risks, unlike most speculative risks, pure risks are typically insurable through commercial, personal or liability insurance policies. Individuals transfer part of a pure risk to an insurer. So when we think about the insurance, if we get a little bit more sophisticated in the thought process in terms of exactly what we're doing, we can say, okay, what am I trying to do here? I'm trying to mitigate my risk. It's a pure risk. I could see that because I could see if this event happened, there would be only loss. What's the likelihood of this kind of event happening that's difficult to calculate? How big would the loss be if it were to happen and then try to make your decision in terms of is it worthwhile to have insurance against that from happening? For example, homeowners purchase home insurance to protect against perils that cause damage or loss. The insurer now shares the potential risk with the homeowner. Now, obviously some of these kinds of things you might say, why do I buy insurance? Because the government makes us buy insurance, which kind of, and that kind of happens too, but it kind of dumps down us as citizens when that happens because then we're making, it's like choosing not to smoke because someone told you that you can't smoke or something like that instead of saying, well, maybe I'm gonna do it on my own accord because I've weighed the pros and cons, which I would think would be a much more healthy thing to do. So the fact that, so there could be other reasons, in other words, why we buy insurance because we're forced to buy something like car insurance and other types of insurance might be required to do certain transactions. But if there's requirements weren't in place, we'd still want to buy insurance in certain instances due to the fact that we're mitigating risk and we most likely would wanna go through this more kind of thought process of what kind of risk is it, what's the likelihood of the risk, what would be the benefits of insurance in that case. So pure risk of insurable partly because the law of large numbers applies more readily than to speculative risks. So when you think about the insurance company side of things, obviously they can't predict what's gonna happen to one individual but pure risk is easier to predict what's gonna happen to a large group of people. And therefore when you put a large group of people together they can then come up with policies that are gonna be reasonable or they can make money with based on the fact that the large numbers are predictable and they can make competitive policies which could be beneficial for both the policy holder and the insurance company can still make profit. Insurers are more capable of predicting lost figures in advance and will not extend themselves into a market if they see it as unprofitable. So obviously the insurance companies need to make a profit with this speculation and that's generally what you want. You want the insurance companies to be competing with each other to try to make profits to try to give the most affordable insurance which means they have to have the best better and better predictions about what's gonna happen in the future than other insurance companies and they can do that with their actuarial tables and their complicated prediction methods they're gonna have. Speculative risk, unlike pure risk, speculative risk has opportunities for loss or gain and requires the consideration of all potential risks before choosing an action. For example, investors purchase securities believing they will increase in value. So clearly when you buy a stock or something like that you're speculating that it's gonna go up in value but it could also go down but the opportunity for loss is always present. Businesses venture into new markets, purchase new equipment and diversify existing product lines because they recognize the potential gain surpasses the potential loss. So when you're in that kind of endeavor you're measuring you're trying to think about what's gonna be the likelihood of the gain versus the likelihood of the loss. So now let's dive into the speculative risk in more detail. This can be found at Investopedia. Speculative risk, take a look at the references, resources continue your research from there. This is by Lucas Downey updated June 3rd, 2021. What is speculative risks? Speculative risk is a category of risk that when undertaken results in an uncertain degree of gain or loss. So we're not just on the loss side of things that's why it's less insurable, less predictable in terms of large number of kind of calculations. In particular, speculative risk is the possibility that an investment will not appreciate in value. Speculative risks are made as conscious choices and are not just a result of uncontrollable circumstances. So typically when we're talking about speculative risk we are involved in the process meaning if you're talking about a fire burning down a home we were somewhat involved in terms of where we chose to live and the likelihood of fires being there and so on but obviously that's more kind of came out of nowhere that the fire burns down the home or something like that. Speculative risk involves us speculating and of course we're gonna be speculating typically with the eye towards getting a gain but having potential for a loss. Since there is the chance of a large gain despite the high level of risk, speculative risk is not a pure risk which entails the possibility of only a loss and no potential for gain. Almost all investment activities involve some degree of speculative risk as an investor has no idea whether an investment will be a blazing success or an utter failure. Some assets such as an options contract carry a combination of risks including speculative risk that can be hedged or limited. So you get into when you start talking about investments of course then you can start thinking about strategies within the investment to mitigate your risk to hedge against your risk. So understanding speculative risk, a speculative investment is one where the fundamentals do not show immediate strength or a sustainable business model. Instead, the trader expects that the price may rise due to other reasons or that future prospects will outshine the present circumstances. Such as security may have a high level of possible upside but also a great deal of risk. This may be a penny stock or an emerging market stock that the trader expects to become much more favorable in the future. Some investors are more speculative than others. For example, investing in government bonds has much less speculative risk than investing in junk bonds because government bonds have a much lower risk of default. In many cases, the greater speculative risk, the higher potential for profits or returns on the investment. A speculative risk has the potential to result in gain or loss. It requires input from the person looking to assume the risk and is therefore entirely voluntary in nature. So we're talking about something we're speculative again that we are actively kind of engaged in in trying to measure that risk. At the same time, the result of speculative risk is hard to anticipate as the exact amount of gain or loss is unknown. Instead, various factors such as company history and market trends when buying stocks are used to estimate the potential for gain or losses. So speculative risk, oftentimes we apply that to open in a business. We're gonna invest in stocks and bonds or we have some kind of gambling that's taking place, possibility for gains and losses in place. You can do strategies to kind of hedge or mitigate your risks as you engage in those items and go that way. And then you've got the pure risk, which is basically if an event happens, you only have kind of like the downside and those are the risks that we typically think that we want to insure against, especially when there's a likelihood that they could happen even though it might be a smaller possibility, but there's still one there. And if it were to happen, it would have big consequences on us financially. Those are the areas that we can try to mitigate with insurance.