In the first article of Understand Insurance section of this blog, What is risk?, we have defined risk as uncertainty of loss. In insurance context, losses are any bad or unpleasant events that can be measured financially.
Risk is basically a state that contains two possibilities, namely a loss or nothing, at one point in the future, far or near.
What makes the risk transform into a loss and how it happens? In the process of risk transformation into loss, there are two factors involved, namely peril and hazard.
Peril is an event that brings about or causes loss. Fires in a house, road accidents, ship sinking, fingers cut by sharp objects, and pickpocket are examples of peril. Death is peril in life insurance. The existence of peril is a main factor that causing the loss. In other words, there is no loss if no peril. Loss simply can’t come out of the blue. In most losses, there are more than one perils working in sequence. The simplest example, death can be preceded by a traffic accident.
Hazard is a condition or factor or feature or characteristic that influences the chance of risk transforming into loss. It could be good and bad influence. Hazard may work in both direction, decreasing or increasing the probability of loss to happen. Hazard that increases the chance of loss is called poor hazard. Conversely, those that reduces the chance of loss is called good hazard.
At this point, you might be wondering, how can there be a good hazard? Isn’t hazard always bad? You are not wrong, the term good hazard does sound odd in daily layman conversation. Word of hazard or hazardous always have negative and bad connotations. However, in the context of risk and insurance there is concept of good hazard as hazard is not merely negative. When we read again the definition of hazard at the beginning of the paragraph above, hazard is defined more broadly and neutrally, it can be good or bad.
The probability of a risk transforming into a loss can be viewed from dual perspectives, namely frequency and severity. Hazard can be associated with this concept. There are hazards that affect frequency and some affect severity. The absence of a smoking ban in a building or premise can increase frequency of fire, but not necessarily increase severity. Buildings made of bamboo or wood are examples of poor hazard that increase severity. A little spark may bring the entire building down, a total loss.
Another example, a wealthy young motorists riding sport car is a poor hazard which may increase both frequency and severity.
The process of risk transformation into loss discussed above, can be summarized in the figure below.