When classifying risk as diversifiable or nondiversifiable, which statement is true?

When classifying risk as diversifiable or nondiversifiable, which statement is true?

• A. Private insurance tends to concentrate on nondiversifiable risks; government insurance is often suitable for diversifiable risks.
• B. The distinction between diversifiable and nondiversifiable risks is clear; risks cannot fall under both classifications simultaneously.
• C. Inflation, unemployment, and natural disasters, such as hurricanes, are examples of diversifiable risk.
• D. Diversifiable risks tend not to be correlated so they can be managed through diversification or spread of risk.

Answer: (D)

Diversifiable risk, also called unsystematic risk, is the portion of risk that comes from factors affecting a small part of the market or a specific asset. Because these risks are not strongly linked across many exposures, they tend to cancel each other out when you spread risk across a diverse set of assets or policies. That’s the core reason diversification works: it lowers overall risk by combining uncorrelated risks. Nondiversifiable risk, or systematic risk, affects broad sections of the market and cannot be eliminated merely by diversification. Inflation, unemployment, and widespread natural disasters are typical examples because their effects reverberate across many assets and industries. The statement here correctly captures the idea: diversifiable risks tend not to be correlated, so they can be managed through diversification or spreading risk. The other statements mischaracterize the nature of these risks or the roles of private vs. government insurance, or imply the distinction is always clear-cut, which isn’t accurate.

Diversifiable risk, also called unsystematic risk, is the portion of risk that comes from factors affecting a small part of the market or a specific asset. Because these risks are not strongly linked across many exposures, they tend to cancel each other out when you spread risk across a diverse set of assets or policies. That’s the core reason diversification works: it lowers overall risk by combining uncorrelated risks.

Nondiversifiable risk, or systematic risk, affects broad sections of the market and cannot be eliminated merely by diversification. Inflation, unemployment, and widespread natural disasters are typical examples because their effects reverberate across many assets and industries.

The statement here correctly captures the idea: diversifiable risks tend not to be correlated, so they can be managed through diversification or spreading risk. The other statements mischaracterize the nature of these risks or the roles of private vs. government insurance, or imply the distinction is always clear-cut, which isn’t accurate.