Does Pure Risk Exist in Business?

Risk text books always used to begin with a section explaining the distinction between pure risk and speculative risk. But is there really such a thing as pure risk in business?

If you read any of the standard texts on risk or security, you will find that risk is traditionally divided into two types: pure risk and speculative risk. Speculative risk is defined as a loss/gain situation, whereas pure risk occurs when the possible outcomes are either loss or no-loss. Thus playing roulette or buying Microsoft shares is considered a speculative risk, whereas being robbed or dying is considered a pure risk.

It's an obvious distinction, but I'm not sure it's a useful one in business.

For example, consider the owner of a chain of gas (petrol) stations . Gas stations tend to be frequent robbery targets (isolated locations on main roads, open when few people are around, cash on premises, etc.) If a gas station gets robbed, there's a loss. If it doesn't get robbed, there's no gain. So robbery must be a pure risk, mustn't it?

But wait a minute. Let's consider the situation before a particular gas station was built. Why did the owner decide to build the gas station? He or she was presumably not acting though some altruistic desire to increase the competition between gas stations. The intention was to make a profit. If the gas station does well, the owner makes money. If it gets robbed frequently, the profit is reduced, and the owner may lose money as a result. So at this point robbery is a speculative risk.

Suppose that now, three years on, the gas station is built, and your favorite data mining program has noted that gas station number 231 keeps getting robbed and is marginally profitable. In fact, the profits are so marginal that you might be better off selling the land and using the proceeds to reduce your working capital. So you're making a choice. Do I continue investing in this high risk gas station, or do I close it and move the money elsewhere? Clearly another speculative risk. And one of the reasons it is a speculative risk is that “pure” risk of robbery.

When faced with an identified risk in business we generally have a number of options:

  1. We can avoid the risk entirely. This might involve subcontracting or setting up a separate business or, as with our hypothetical gas station owner, getting out of a business altogether.
  2. We can reduce the risk by taking appropriate steps to reduce the likelihood of something happening. Our gas station owner might choose to install improved video surveillance systems, eliminate cash transactions, or employ an armed guard.
  3. We can spread the risk by splitting operations between multiple locations. (This increases some risks, but decreases others).
  4. We can transfer the risk, generally by means of an insurance policy. (From the insurance company's perspective, they spread the risk by having multiple insured parties).
  5. We can assume the risk, by not doing anything about it. Most companies assume risks involving minor losses, since the cost of any other option is greater than the losses involved.

Where we have option (1), risk avoidance, risks are always speculative. Let's therefore consider the cases where the option of total risk avoidance doesn't exist.

If we consider personal risk management, it's clear that we don't always have the avoidance option. Memento mori — Remember you must die. Sure, we can try and live a risk free existence, eating carefully, keeping ourselves fit, and avoiding doing anything particularly dangerous. But we can't avoid the risk of dying, only reduce it. One day old age, disease, accident, or that crazed ex-spouse is going to get us. There's no way of avoiding this risk altogether.

But in business risk management, we almost always have the risk avoidance option because we can just take our winnings (or losses) rather than continuing to risk them in an enterprise.

Almost always? I can only think of only a few situations where it isn't an option. Firstly, if you are a minority shareholder in a private company. There is often no way you can cash out your investment, no matter how much you want to. You no longer have control of your asset, and must be content to watch it succeed or fail from a distance.

Secondly, you can't do anything about the risks associated with a company's past deeds. If your company has been doing something illegal, incurred a liability it can't pay, or has not been paying its taxes, then it's the courts or the government that has first call and ultimate control of the company, not its owners.

Finally if (like most of us) you work for a company, rather than just own it, then avoidance is probably impractical. You have to play the cards you are dealt and reduce, spread, transfer, or assume each risks. Unless, of course, you want to change jobs.

Reader Comments:

Dominic Strong writes:

I have just read your document and would like to maybe clear up the idea of pure risk and speculative risk that you are having. A robbery is a pure risk as you rightly stated. There is never a possibility of gain. A company can have and usually has many risks at the same time. Some of these may be pure risks and some may be speculative risks. In the case you mentioned robbery does not become a speculative risks as it never has a possibility of gain. The manager of the gas station just has to deal with both speculative risks (whether or not the gas station will be profitable) and pure risks of which robbery is just one.

I agree that from the manager's point of view it is a pure risk. But my point is that from the owner's (or higher management's) point of view operating the gas station is speculative, with the risk of robbery being just part of that speculative risk. It depends very much upon where you sit as to whether a risk is classed as pure or speculative.

21 January 2005

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