What is it?
Before you can participate in the complex risk-management process, you need to have a general understanding of the concept of risk itself. In very broad terms, risk is the possibility of harm, injury, loss, danger, or destruction. Risk can be further subdivided into two basic types: speculative risk and pure risk.
Speculative risk has the potential for either gain or loss, much like the financial risks you assume when you put your money into certain investments.
Pure risk, on the other hand, has no potential for gain; it can only result in loss or no loss. Most of the risks to which you are exposed in your life are pure risks. An example would be the risk of an accident each time you drive your car. The worst possible outcome is that you will be involved in an accident, while the best-case scenario is simply that you will have an uneventful, accident-free trip.
All pure risks exist because of various dangers known as perils. Perils are the actual, direct causes of loss and include death, disability, illness, fire, theft, and accident, among other things. In contrast, hazards are acts or conditions that could increase either the severity of a loss or the chances of a loss happening in the first place. A simple example will illustrate the distinction between a risk and a hazard:
Say you leave a cigarette burning in your living room. It falls to the floor, the rug catches fire, and your house (along with all the property in it) goes up in flames. Fire was the peril that directly caused the loss in this case, while the unattended cigarette was the hazard that increased the likelihood of a fire occurring.
Why should you manage your risks?
The combination of perils and hazards creates risks to which you are vulnerable every day of your life. These range in severity from your risk of dying to something as minor as your risk of coming down with a common flu bug. They also vary in likelihood from high-frequency to low-frequency risks. Your chances of getting the flu at some point in your life are obviously much greater than your chances of perishing in an airplane tragedy. But whatever its likelihood or possible severity, every risk carries the potential for some type and degree of loss. If you don't have medical insurance, even the risk of the flu can produce financial losses in the form of such expenses as doctors' visits and prescription drugs.
In effect, if you want to minimize the losses associated with different kinds of risks, you need to develop a plan for dealing with risk. This plan should treat each specific risk you face on an individual basis while simultaneously addressing them all together as a total package of risks. This is where risk management comes into play.
You should pursue a plan of risk management with the help of additional resources. These may include qualified professionals such as a financial planner, an insurance specialist, a CPA, and/or a property casualty expert.
Objective of risk management
Given the number and variety of risks that exist in the everyday world, the basic objective of risk management should be fairly obvious. Risk management is simply intended to combat the risks you face in your life and, in so doing, to minimize the financial and other losses potentially associated with those risks.
In general terms, the risk-management process involves taking steps to cope with risk and thereby to minimize losses. If you want to undertake a comprehensive plan of risk management, here are the basic steps you should follow:
Not surprisingly, these steps toward personal risk management are very similar to the steps that risk experts take in an effort to manage risk for major corporations. If you follow them properly, you are well on your way to achieving the basic objective of risk management.
Use additional resources to help you with the process
No matter how you look at it, risk management is a lengthy and involved process. As you go through the process, remember that your life and the risks that come with it are unique. With this in mind, one of the most important rules of risk management is to make sure that your plan is specifically tailored to your individual circumstances.
Identifying potential risks and losses
The first step of the risk-management process is to identify the various risks you face and the potential losses that may result from them. Unfortunately, this is not as easy as it sounds. With the help of your additional resources, you must collect and analyze information on your assets (your investments and real estate, for example), your liabilities (your outstanding debts), your salary and other sources of income, and your age and health, among many other things. This kind of data-gathering allows you to zero in on some of the major areas that need to be addressed. You can start by identifying obvious risks (such as death, illness, fire, theft, and loss of a job) and determine what financial losses you and/or your loved ones would suffer in each case.
Some important considerations for identifying risks and potential losses include your lifestyle, your existing insurance, and your relationship with your advisor(s).
Your existing insurance may make it easy to pinpoint the areas where you're vulnerable to loss and other areas where you're not. Insurance is specifically designed to safeguard you against the risk of loss. Assuming you have carefully chosen the type(s), coverage and amount(s) of insurance you need, you may already have enough protection against certain kinds of losses. If so, your chance of loss in those areas is minimal, so you can forget about them and move on to other areas, if any, where your protection is not as adequate. Let's say you have $500,000 of life insurance coverage but no health insurance. While you may not need to worry about how your family will get by if you prematurely die, you should consider how you'll pay the medical bills if you're suddenly stricken with a serious illness that's expected to drag on for years.
Insurance is by far the most common and generally the prudent strategy for managing your risks and losses. It's no coincidence that so many people have life, health, auto, and homeowners insurance. By weighing the price of protection against the potential benefits--not to mention peace of mind--most people conclude that insurance offers the most effective, cost-efficient way to cope with risk and guard against financial loss. No one likes to pay insurance premiums, but the cost will be well worth it if the covered loss actually occurs and the company comes through with a large amount of money when you need it.
When you buy insurance from an insurance company, you are essentially entering into a contract with that company. You pay premiums and, in return, the company agrees to indemnify or cover you for specified losses. If you take out auto insurance, for example, your company may provide financial coverage (according to the terms of the policy) for any medical expenses and property damage resulting from a car accident that involves you. In general, you are free to cancel the contract any time you choose. You simply stop paying the premiums, and your company will not cover you anymore if something happens. However, the company will generally be obligated to cover you for the term of the contract as long as you keep paying your premiums on time. The basis of the insurance contract is the principle of risk transfer.
You reduce your individual risk of loss by shifting part of it to your company and sharing it with numerous other policyholders covered by the same company. This way, you receive protection against risks that you would probably not be able to cope with by yourself. Your company also benefits in that it takes advantage of risk pooling and the law of averages to generate more money than it pays out in claims. Insurance is not, however, the solution to every problem that involves risk. In fact, strange as it may sound, insurance is generally not the appropriate strategy for many kinds of high-frequency, low-severity risks or losses. The greater the probability of loss, the higher the average loss per insured and the higher each policyholder's premium will be. Thus, if the risk in question produces minimal losses each time it occurs, it may be cheaper and smarter to pay out-of-pocket for these losses yourself on an occurrence basis rather than to shell out a lot of money for an expensive insurance policy. In contrast, insurance is perfect for most low-frequency, high-severity risks or losses such as death and terminal illness. Because the likelihood of the covered event occurring is so low, the cost of the insurance is correspondingly lower. At the same time, the potential benefit is great, and generally exceeds the protection that any other risk-management strategy could provide for these kinds of losses.
If you are considering insurance, there are specific considerations you should understand for each different kind of insurance. For more information, see our discussions of Life Insurance, Health Insurance, Disability Insurance, and various types of Property and Casualty and Liability Insurance.
Selection of insurance coverages
Your first step is to decide what type(s) of insurance you want based on the kinds of risks or losses you want to guard against. This is relatively easy for the average person because most of us have the same basic protection needs. You will probably conclude that you should have life, disability, health, homeowners, and automobile insurance. There will be exceptions to this general rule, of course. You probably don't need auto insurance if you don't drive, just as you won't need homeowners insurance if you don't own your own home (although you may need renter's insurance if you rent). You may even be in a position to forgo life insurance if you have sufficient resources to self-insure. On the other hand, you may determine that you need other forms of insurance above and beyond the four basic types. This may include, among others, personal liability insurance (also called an umbrella policy).
Whatever types of insurance you choose to have, the process of building an insurance program becomes more involved when you've made those decisions. Now you must select the right type and amount of coverage within each category of insurance. With homeowners insurance, for example, you must decide what property items (e.g., jewelry and antiques) you want covered besides your home itself and what particular perils (e.g., fire and floods) you want to guard against. In addition, based on the value of the covered property, you'll need to determine an appropriate coverage level or maximum dollar amount up to which your insurance company will cover you for financial losses. Keep in mind that there may be separate coverage limits for specific types of property and perils. You can follow the same general guidelines with auto insurance. Here it's particularly important to select appropriate coverage levels for medical expenses and property damage resulting from collisions. Beyond that, determine what else you want covered (e.g., theft, vandalism, glass, towing and rental) and up to what amount(s).
With life insurance, the process can be considerably more involved than with other kinds of insurance because there are so many factors to consider when choosing the best policy with the right type and level of coverage. Among other things, you need to take into account your age and health, your occupation, your current income, the value of your assets, your family make-up, and anticipated future expenses. You may even need to employ complex mathematical formulas to help you arrive at an appropriate coverage level figure.
With all types of insurance, particularly life insurance, you should consult additional resources to help you select the appropriate type(s) and amount(s) of coverage.
Guarantees are based on the claims paying ability of the issuing insurance company.