The Classification of Risks

The Classification of Risks

Willett recognized that risk is commonly used in an ambiguous manner and

sought to construct a more precise definition. He first proposed to classify risks

in two categories, economic risks, because their existence is due to participation

in economic life, and in contrast extra-economic risks, the existence of which is

not the result of economic activity. He mentioned that such risks may also

affect economic activity but he was only concerned by economic risk.

Static and Dynamic Risks

Willett considered that a fundamental classification of economic risks is based

on the distinction between static and dynamic losses. A similar classification

was suggested by Von Mangold between technical and economic losses. 1 I An

alternative classification was presented by Hardy and distinguished the

followings: (1) risks of destruction through physical hazard, (2) uncertainties in

the production process, (3) risks resulting from market changes, (4) risks caused

by "abnormal" social conduct and, (5) risks arising from the failure to use

available knowledge.

Dynamic risks are those involved in the possibility of dynamic changes.

They are resulting from changes in the economic conditions such as price levels,

consumers tastes, saving behavior and technology. They usually benefit the

entire society in the long run.

Static risks involve losses that would occur even if there were no changes in

the economy such as accidents, fires and other perils of nature. These losses are

also caused by irregular action or mistakes of human beings. They could be the

source of gain for an individual but usually static losses involve the destruction

of assets and are not a source of gain for the society.

Pure and Speculative Risks

The distinction between pure and speculative risks is usually attributed to

Mowbray. 13 In the first publication of the American Economic Association,

Professor Emery distinguished risks of production from speculative risks.14

Risks of production were not defined but speculative risks were "the risks of

price fluctuations affecting the whole market. "

Speculative risks describe a situation where there is a possibility of a loss as

well as a gain. The activities generating such risks are usually undertaken in the

hope of a gain. Gambling is a good example of a speculative risk. Investments

in risky assets are vohmtary accepted although price fluctuations can either

benefit or deprive the owner.

Pure risks are those that offer only the prospect of a loss. Therefore, perils

of nature or consequences of human errors are usually only pure risks.

There are some borderline examples were it is difficult to classify the risk

because the process is dynamic and the result may be a short term loss which

could result in a gain in the long term. A strike results in losses for the workers

and the firm but in fact the outcome is a new labor contract which carries the

prospect of improved work conditions and/or salaries and higher expected

productivity and profits for the firm. The consequences of a war can also be

appreciated in different ways. A nationalization results in the loss of property

due to a dynamic change in the country but in fact the decision of investment

usually incorporates a premium for such a risk in the required rate of return on

the investment.