Continuing this series on concepts from my professional studies for those looking to improve
their finances. This time we’ll cover risk management fundamentals, including common terms,
concepts, and outline the risk management process.
Life is full of risks ranging from catastrophic to insignificant. Any of us could twist an ankle
stepping out of bed, be rear-ended in traffic, or get struck by a rare disease.
It’s neither possible or desirable to eliminate all risks. A riskless life would not be worth living.
Rock climbing, ballroom dancing, sports betting — we all have things we enjoy that involve
some level of risk.
Investors who want to pursue growth must likewise bear some amount of risk. Savings
accounts, money market funds, and government securities that contain minimal market risk are
available. But long term historical data shows that those vehicles fail to maintain the purchasing
power of wealth – inflation overwhelms them over time. Diversified equity portfolios, in contrast,
have offered long-term returns well over and above inflation, and more volatility with those
returns.
We have a choice: Try to preserve purchasing power and take market risk, or try to avoid
market volatility and risk losing to inflation. The more of one we choose, the less of the other we
have.
Bearing risk is costly, and so is mitigating it. It’s a tradeoff.
The goal of risk management is to evaluate where we’re over (or under) exposed to various
types of risks, and intentionally determine which ones to take (or avoid), acknowledging the
inherent tradeoffs involved.
From a financial planning perspective, a big part of this process is to reduce the impact of
catastrophic risks on our financial lives and those of our loved ones.
Let’s dive in 👇🧵
TERMINOLOGY
Risk: Possibility of loss / negative outcome
Peril: Cause of the loss (fire, wind, etc)
Hazard: Increases likelihood of loss (driving on bald tires)
TYPES OF RISK
Static Risks: Regularly occurring events unrelated to financial markets (death, earthquakes) –>
insurable
Dynamic Risks: Economic and business risks whose timing is uncertain (recession) –> not
insurable).
Pure Risk = 2 outcomes: Loss or nothing (e.g. risk you become disabled)
Speculative Risk = 2 outcomes: Loss or gain (e.g. gambling)
RISK MANAGEMENT PROCESS
Establish Goals
- Identify high value property.
- How much loss can be tolerated?
- What risks are prominent? Active lifestyle –> Liability | Inactive –> Health
- How much “lifestyle” do you want to protect (understanding there is a cost for doing so)?
- Compare potential financial loss & consequences vs. probability —> determine appropriate
action - What % of income should be used for risk mitigation (~ 10% is reasonable for young families.
Varies depending on preferences and stage of life)
Gather Data
- Medical history (illness / injury)
- Inventory possessions and animals
- List hobbies, professional duties, volunteer activities
- Examine current policies (homeowner’s, auto, life, etc)
- Examine personal balance sheet, assets vs. liabilities, tax return, pay stubs. What level of
protection needed to meet liabilities??
Identify Risk Exposures – Which can you afford to retain/not?
- Asset related (lost use i.e. car, home)
- Contract law – liability to parties involved
- Tort law – liability resulting from activities
From here you can develop a personalized risk management plan, and look to execute it.
RISK MANAGEMENT STRATEGIES
Some focus on insurance / risk transfer, but that’s only one of multiple risk management options. We can also:
- Avoid the risk (stop smoking)
- Reduce it (fewer Vegas trips)
- Retain it (liability only coverage on an old car)
This is where tradeoffs come in. Any of these methods has a cost involved. None are right or
wrong, it’s up to us to determine what we can live with. Paying the deductible on health
insurance is costly and so is going to the emergency room.
PLANNING IMPLICATIONS
More Risk Retained = Larger Emergency Fund Needed. We can choose to finance risk
ourselves, but if so we should ensure there is cash on had for that purpose.
Higher Cash Needs = Lower Risk Investments (in case savings deplete).
INSURANCE CONCEPTS
Insurable Interest = Will you be financially impacted if the insured event occurs?
- Property (home/auto): needed at time policy is issued AND at time of loss (you sold the car,
can’t collect) - Life: only needed when policy issued (former spouse can still collect)
Deductible: Retained risk (insured pays this)
Face Value (limit): Max amount paid if loss occurs
Subrogation: Insured cannot collect twice for the same loss
Actual Cash Value (property) = Replacement cost – depreciation
Coinsurance: Cost-splitting b/w insurance co. and policy holder
Adverse Selection: Risk takers are more likely to buy insurance.
- Dilemma for insurance co.’s who must balance the pool of policyholders between low and high
risk.
Elimination Period: Length of time before benefits are paid (ensure sufficient savings on-hand to
cover )
COVERAGE BASED ON LIFE CYCLE “PHASES”
Accumulation 📈 – early adulthood through mid-40s (or when kids are independent).
- Higher debt + lower cash flow and net worth are typical in this phase
- Likely insurance needs: Health, disability, life, casualty
Conservation / Protection🛡 ~ age 45 – 60 or pre-retirement.
- Cash flow & net worth typically increase in this phase, while debts decrease
- Health, disability, life may still probably appropriate. Good time to consider buying long-term
care insurance.
Distribution 📉- retirement through end of life.
- Disability & life insurance likely not needed or available.
- Health and LTC coverage become prominent
- Property / casualty for wealth protection
These are general categories. A person can occupy more than one phase simultaneously.💡
That’s all for now. Next we’ll continue this series by summarizing key aspects of life, health, and
property insurance.
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