Peril and Hazard

In the context of risk, particularly in insurance and risk management, peril and hazard are distinct concepts that help to identify and understand the sources and factors that contribute to potential losses.

1. Peril:

• Definition: A peril is the cause of a potential loss. It is the specific event that can lead to damage, injury, or financial loss. Think of it as the "what" that causes the loss.

• Examples:

  • Fire: A fire can destroy a building or its contents.
  • Theft: Theft can result in the loss of assets.
  • Flood: A flood can damage property.
  • Earthquake: An earthquake can cause structural damage.
  • Death: In life insurance, death is the peril.
  • Market Crash: In investments, a market crash can cause significant losses.

• Focus: Perils are the events that insurance policies typically cover. The policy specifies which perils are insured against and which are excluded.

2. Hazard:

• Definition: A hazard is a condition that increases the probability of a loss occurring due to a specific peril, or increases the severity of the loss if the peril does occur. Think of it as the factor that makes a peril more likely or more damaging; the "why" that makes the peril more likely or severe.

• Types of Hazards:

  • Physical Hazard: A physical condition that increases the chance of loss.
    • Example: Faulty wiring in a building (increases the risk of fire).
    • Example: Icy roads (increases the risk of car accidents).
  • Moral Hazard: Arises when having insurance encourages riskier behavior because the insured party is less concerned about potential losses.
    • Example: A business owner with fire insurance being less diligent about fire safety.
    • Example: Overusing health insurance benefits because the cost is largely covered.
  • Morale Hazard (Attitudinal Hazard): Carelessness or indifference to a loss because of the existence of insurance. Similar to moral hazard but stems from apathy rather than intentional misconduct.
    • Example: Leaving doors unlocked because "I have insurance anyway."
  • Legal Hazard: Conditions in the legal or regulatory environment that increase the chance of loss.
    • Example: Changes in building codes that require expensive upgrades after a fire.
    • Example: Court decisions that increase liability for certain actions.

Relationship between Peril and Hazard:

Hazards influence the likelihood or severity of losses caused by perils. A peril is the event that causes the loss, while a hazard is a condition that makes that event more likely or its consequences more severe.

Example:

• Peril: Fire
• Hazard: Poorly maintained electrical wiring (physical hazard) increases the likelihood of a fire. Storing flammable materials improperly (physical hazard) increases the severity of a fire.

Importance:

Understanding perils and hazards is crucial for:

• Risk Assessment: Identifying potential perils and the hazards that can exacerbate them.
• Risk Management: Implementing strategies to mitigate hazards and reduce the likelihood or severity of losses.
• Insurance Underwriting: Insurers use information about perils and hazards to assess risk and determine premiums.