Risk is a fact of life. We might not like it, but it’s not going away.
There are two types of risk:
- Pure Risk: We can only lose if an event occurs; for example, the risk of a flood doing damage to your house in any given year. Either the house is damaged by flood, or it is not. This type of risk is generally insurable.
- Speculative Risk: We can lose, gain, or stay the same. Gambling is an example of speculative risk. You can win money, lose money, or come out even. This type of risk is NOT traditionally insurable (although there are sometimes ways to hedge these risks, like diversifying your investment portfolio).
In this article I will focus on risks we face outside of the investment world. Risks within the investment world we will cover on another day. The primary goal of personal Risk Management (RM) is to protect one’s goals, dreams, treasure and personal well-being from those “what ifs” that might become “what now”?
RM is not a static process. The risks that we face and the strategies that we use to protect ourselves change as our personal financial circumstances change. Where we are in our financial lifecycle matters, too. For example, during our early earning years we tend to have many commitments; kids, mortgages and car loans, and relatively few financial assets. Premature death and disability are key risks to our goals so we look at life and disability insurance to offset those risks. On the other side of the coin, during our retirement years, we tend to have fewer financial commitments and less reliance on earned income but more financial assets and cash flow from pensions or social security. Healthcare, assisted living and liability issues are key risks to our lifestyle and legacy goals then, so we look at Medigap, long-term care and personal umbrella insurance policies to offset those risks.
The RM process involves three steps:
1. The cause and nature of the risk should be identified. For example: Premature Death, which leaves the family to cope with lack of income to pay debts and living expenses.
2. A determination should be made of how much risk a person should be willing to retain. In the case of a homeowner’s policy, how much of a deductible should be assumed? Or, if you live in the mountains, should events such as earthquake or flood be covered, since they are unlikely to occur?
3. Determine how to handle risk NOT retained. A crucial RM factor is to balance the expenditure of insurance premium dollars against the risks that present the highest negative impact to the individual’s personal financial plan. We could insure ourselves from almost any risk but go broke paying the premiums.
There are five distinct methods, or strategies of dealing with risk:
1. Risk avoidance: Avoid those high risk activities in your life that, should they happen, would be catastrophic to your personal financial plan. Examples of these activities would be speeding, dangerous sports, smoking, etc.
2. Risk retention: To personally assume the risk, in essence self-insuring. In this case the risk must not impose a substantial financial or non-financial threat to you. For example, “I do not insure my life because I have no debts or obligations,” or “I forego long-term care insurance because I believe I have enough in financial assets and cash flow to pay out-of-pocket for this type of medical care.”
3. Risk reduction: There are two sub strategies to this method: Loss Prevention and Control, for example: use of fire and burglar alarms, air bags, and smoking and weight control programs. Risk reduction can also involve minimizing risk by using an insurance company that uses the law of large numbers to maintain their solvency.
4. Risk sharing: In this strategy one assumes a limited degree of manageable risk and transfers the balance of the risk to one or more organizations. For example, I choose a high deductible health plan that would require me to pay the first $5,000 of any major health bills, but would then pick up 100% of the cost after that. This risk sharing agreement allows me to cut my monthly insurance premiums by 40%. I can cover the $5,000 in risk and hope that over the long run my reduction in premiums justifies the risk of having to pay $5,000 out-of-pocket.
5. Risk transfer: I transfer risk completely to a third party in consideration of an insurance premium. Life, disability, and liability risks are often dealt with in this way.
These strategies can be used to design a RM foundation balancing premium outflows with the impact of a risk based event:
Sky Diving – High Frequency, Loss Likely. Avoid this risk. (Don’t sky dive.)
Disability – Low Frequency, Loss Likely. Transfer or Share this risk. (Get disability insurance to replace part of your income.)
Flu – High Frequency, Loss NOT Likely. Reduce this risk. (Have medical insurance, but also wash your hands often.)
Vacation Insurance – Low Frequency, Loss NOT Likely. Retain or Share this risk. (Consider vacation insurance on a case-by-case basis.)
Getting assistance with risk management analysis can often be problematic. Insurance salespeople are the typical risk consultants available today but because they are compensated by product and insurance sales commissions or are biased to their respective areas of risk expertise, they can often cloud what is in the best interest of the overall personal financial plan.
A Fee-Only® financial advisor is dedicated to providing you with the most comprehensive and objective risk management analysis and keeping it in sync with any changes in your financial situation or personal financial plan. Contact your financial strategist with any questions on your risk management plan. Not a client? Get started online now.