There are many things in this world that can cause you financial harm. Your exposure to harm from these events is your risk. Though many people are aware of risks in financial markets, fewer consider risk in its broader perspective.
The Realms of Risk
Beyond the notion of investment risk — and all investments have risk — we can apportion risk into three main categories as it applies to our financial lives.
We have health risk; we could become injured or ill and need medical attention. The cost of medical care is high. There is a real risk that a significant medical event could bring major financial consequences, unless, of course, we deal with the risk.
We have risk to our property. The things we own face the risk of loss. Losses can occur due to theft, fire, or other events. In addition to the risk to property, we have a liability risk which is often associated with that property. We could be found liable for damages to others.
For example, someone may be injured on your property, and you could be legally responsible. For higher value properties, or possessions with an elevated risk of injury, we need to address this risk to protect our financial futures.
We have risk to our ability to earn an income. Generally, for most of our working years, our ability to earn an income is our greatest asset. If we become unable to earn an income due to sickness or injury, our financial health can suffer dramatically. This risk should also be addressed to protect our financial futures.
Ways to Manage Risk
For our personal financial risk, there are three basic ways to manage the potential consequences.
We can retain the risk, if we see the consequences as relatively minor, and are willing to take that risk. We do this with minor possessions, where we don’t worry about loss or damage because they are easily replaceable.
We can mitigate the risk. We do this by taking actions that reduce the likelihood of an occurrence of damage or injury. For example, we might choose to drive carefully, or to install a burglar alarm. Both of these mitigate risk by reducing the probability of loss.
We can transfer the risk. When we talk about risk transfer, we aren’t actually transferring the risk of occurrence, but rather the financial costs of that occurrence. For example, having fire insurance on your house doesn’t change the likelihood of having an unexpected fire, but it transfers the financial consequences of that occurrence to an insurer.
In some cases, a combination of methods may be appropriate. We often, for example, retain a small risk while transferring a major risk: an insurance deductible being the risk we retain, the remainder being transferred to an insurer.
Let’s consider our risk management options in each of the three non-investment realms.
Risks to Your Health
Uninsured medical bills are a common cause of bankruptcy in the United States. This does not need to be the case.
Medical insurance is available from a variety of insurers, and at a wide range of costs. A significant factor in cost is the policy’s annual deductible. The deductible is the amount of medical costs the policyholder must pay out of pocket before the insurer starts picking up their share of the costs.
The deductible is one way to manage risk. A higher deductible has you retaining more risk and a lower deductible has you transferring more risk — but at the cost of a higher premium.
A factor in making the decision is your own health. Some people need medical services on a regular basis and would be best served by a policy with a low deductible. Others rarely need medical services and may be better served retaining a higher level of risk.
Age is also a factor in risk. People tend to need more medical care as they get older. The necessity of nursing home care is highly correlated with age.
Naturally, the amount of risk that can be comfortably assumed depends on the size of your emergency fund. A key aspect of building an emergency fund is that it allows you to lower premiums by retaining an increased amount of risk, when it otherwise makes financial sense to do so.
Risks of Property and Liability
This is one area with which people tend to have the least conceptual trouble. Most states require auto insurance for you to exercise the privilege of driving in the state.
The intent is not to protect your property; it is to protect the property of others from damage you cause.
Your bank will insist you protect an asset securing a loan; the bank is interested in knowing its collateral is protected.
Within the realm of property and casualty insurance, we can still utilize the three risk management techniques. We can reduce the risk of an occurrence by maintaining our properties and by how we operate them — whether they be a car or a building. Mitigating risk is an important factor in overall cost reduction.
Generally, we need to transfer some property and liability risk to an insurer. Most of us would not willingly assume the risk of fire or other major calamity to our home, although we might be willing to work with a relatively high deductible to keep our premiums more affordable.
Risks to Our Earnings Ability
The risk to our ability to earn an income is often not adequately addressed and represents a significant risk to people’s financial futures. Our ability to earn an income can affect our financial future, if we become sick or disabled and are unable to earn income.
Our ability to earn an income can also affect the financial futures of those who depend on us for support. This could be as the result of an injury or illness, or it could be the result of our premature death. We would generally deal with these two possible scenarios separately.
Our risk of loss of income due to illness or injury can be mitigated, retained in whole or in part, or transferred in whole or in part. We transfer this risk through the use of disability insurance.
As with other insurances, we can retain a portion of the risk by selecting when or why we get paid.
For disability insurance, we can increase the waiting period, retaining the risk for shorter term disabilities of weeks or months — once we have built up a cushion to make this affordable.
Disability insurance should always be a temporary need. Our need is generally greatest during our earlier years of employment, and should no longer be a need once we have achieved financial independence. Once you have achieved financial independence, your financial future is assured and your need for disability income protection falls away.
Life insurance protects the financial future of those who depend on you, or, in some cases, others to whom you wish to leave some financial benefit. It is most often used to provide for a surviving spouse or children in the event of the premature death of a primary breadwinner — which, for many couples, is often both spouses.
The need for life insurance should also decline once financial goals are met. For example, once a family has educated their children, they no longer have that capital need in the event of a premature death.
The Bottom Line
Managing our non-investment risk is an essential part of planning for a financially healthy future. In considering the techniques of retention, mitigation, and transfer, we often consider two aspects of a risk.
The fundamental aspects that define how to manage risk are its potential cost and the probability of the risk occurring.
For a risk with a high probability and a high cost, we avoid the risk — we mitigate it completely. We don’t jump out of airplanes without parachutes, as both the cost and probability of a negative event are astronomical.
For events with a low cost and a high probability, we retain the risk. We don’t generally concern ourselves with the risk of individual low-cost items, as they are easily replaceable.
The cost to transfer that risk would typically be excessive in relation to the item’s cost. You wouldn’t take any specific steps to deal with risk for an item such as a pen, as you can replace it easily if lost or damaged. If your pen cost a couple thousand dollars you might deal with it differently, but that’s not the typical situation.
For events with a low probability and a high cost, we typically transfer the risk. Fire insurance for our homes is a great example for this. The risk of losing your home due to fire is relatively low, but the cost is more than most individuals could easily bear, so we transfer the risk, or at least the bulk of the risk, to an insurer.
This approach can be useful in assessing any risk we face. We can consider our options, the probability of a negative occurrence, and the cost of that occurrence. When we can’t absorb the cost into our budget, we should consider other ways to deal with the financial costs of the risk.
If we can’t avoid the risk, we may need to transfer the risk to an insurer. But if the cost of an occurrence is low, we will generally be better served by retaining the risk and paying any costs from our emergency funds.