What is a peril?

In a previous post, I loosely defined risk as “the possibility of something bad happening”. But what about industries that look at risk professionally? Let’s start with the financial services industries, notably insurance [the industry I happen to know best, having dabbled in it for close to 30 years] and banking.[1]

In financial services (FS from now on) overall, the focus of the term risk is more on the uncertainty of the outcome. Risks in that sense can have a negative outcome (a loss), a positive outcome (a gain) or neither. When you buy a company’s stock, you are taking a so-called speculative risk, and the stock can go up or down.

Insurance generally doesn’t deal with speculative risk, but rather with “pure risk”, which means there is no gain possible. The role of insurance doesn’t actually protect against risk itself, but rather from the financial loss associated with that risk. Simply put, the insurer assesses the likelihood of the “something bad” happening to you, the cost of making you whole again (called “indemnifying”) and then offers to cover that risk for a premium. There is lot of mathematics (called actuarial science) behind the whole thing, as insurers have to make sure that the risks they take on balance out so there is no single event that can wipe out their whole portfolio. Which is why it’s so hard to get flood insurance in Florida right now – if Florida goes under, large parts of Florida go under, and that’s a big acccumulation risk (another insurance term, only this time the risk is for the insurer, not for you as customer). So what’s a peril? For an insurer, it’s the cause of the damage – fire, flood, car accident. The risk, on the other hand, is the probability that that peril will cause the loss, whereas a hazard is the thing that helps the peril along. If you find this confusing, don’t worry, I am almost done, just one quick example. The DIY home improvers among the readers might have worked with linseed oil to finish wood work. It is often applied with a rag. That rag, when left somewhere to dry can spontaneously combust, causing your shed to burn down. The rag is the hazard, the shed fire is the peril, and the whole thing with its probability is the risk. Clear?

Things can get even more complex when we move to the banking side of FS. Since financial markets are mostly concerned with, well, financial markets, this is all about investments into various businesses, assets, stocks, bonds etc. Banks define risk as the chance that an investment’s actual gains will differ from the expected outcome. Assessing risk in banking means understanding past deviations from those expected outcomes, and then devising strategies to manage them such as diversification.[2]

There are many different types of risk in the banking view, from credit default risk and foreign exchange risk to political and liquidity risk to counterparty risk. Basically risk is everything that can affect an investor's ability to invest and make a positive return.

If you’ve read this far, congratulations. I’ve tried to simplify as much as possible, which is why I’ll also leave legal aspects and other fun terms like alpha and beta for another day or post – if necessary.

[1] Even within the sector, there can be a bit of confusion on what comprises financial services and its industries – is insurance in or not? What is banking? For simplicity’s sake, and at the risk ()  of annoying some experts, this blog will be saying financial services when I mean everything, insurance for insurance, and banking as a blanket term for retail banking, investment banking and financial market activities such as brokerage etc. But don’t worry, except for this post we won’t be going into these weeds all too much.

[2] For example, Nassim Nicholas Taleb, in his (very readable) book Black Swan, proposes investing 90% of assets very safely with very low returns, and the spreading the rest among so-called White Swan investments, which have an extremely high yield at a low probability.