What Does Speculative Risk Mean?
A speculative risk is an event that one cannot predict whether it will produce a profit or a loss. When an outcome cannot be predicted but results from choices a person makes of their own volition or free will, that risk is considered speculative. It is taken on by someone aware of the uncertainty, but who accepts the high-risk, high-reward possibility. Examples of this type of risk include investments, buying stocks or gambling.
This type of risk is less likely to be insured or may not be insured at all. Insurance is designed to get one back in the same financial position they were in before a loss. This is known as risk transference — the transference of the risk of financial loss to the insurance company in exchange for a premium. Insurance is not designed for the purchaser to profit, just to come out even. As a result, insurers decline risks that one can profit from, such as speculative risk.
Speculative risk is the opposite of pure risk, which is a risk that is inevitable and can result in either loss or no loss, but never gain. Pure risk can be covered by insurance because of its predictable nature. While pure risk cannot be controlled (natural disasters, death, fires, etc.), speculative risk-takers choose to put themselves and their money at risk.
Insuranceopedia Explains Speculative Risk
Insurance companies cannot afford to take on speculative risk because of how volatile the outcomes are. They rely on objective risk assessment to determine the probability of an event — basing their opinion of the likelihood of the event on statistics and the law of large numbers. The law of large numbers is the principle of using a collection of data to determine probability. The larger the pool of data, the more accurately the outcome can be predicted.
Insurance companies use actuaries — highly trained professionals in probability statistics and data analysis — to determine the likelihood of an event happening. Then, based on the probability of the event, they determine a premium. If it is not likely to happen, the insurance premium will be less expensive than one that is more likely. For example, if an area often gets hail in the summertime, the premium for that coverage will likely be higher than in the next town over that gets less hail.
Almost all business activities and ventures qualify as speculative risks, from opening a new location to adding new items to the stock. As such, insurance companies will not directly insure the business’ profit. However, commercial insurance may cover the building, stock, equipment and other physical properties required to do business.
Lifestyle actions are also considered minor speculative risks. For example, one may take a job with the speculation that it will provide financial gain. Unemployment, on the other hand, would be a pure risk because the outcome could only be financial loss without the prospect to gain anything. To reduce the financial loss of unemployment, people pay into unemployment insurance.
In finance, some stocks may be more speculative than others. For example, more stable or government stocks would be less speculative because their history makes them more predictable. Buying penny stocks or stock in companies that are new to the market is more speculative. To mitigate the impacts of speculative risk, the most effective method is risk avoidance. This means avoiding putting oneself at risk of any loss or gain. One cannot suffer a huge loss if they do not buy the stock in the first place.
The degree of participation in actives that have speculative risk depend on one’s risk tolerance — how comfortable they are with the possibility of losing it all. Speaking to a financial adviser, insurance broker or agent, or other professionals may be able to provide some insight into the risk of participating in an activity as well as the effect of a total loss of the investment. The prospect of major gain can be exciting and life-changing, but only if one is willing to accept the risk that it could go the other way.