Chapter 20 - Risk Management

Life is full of dangers and risks. We never know what may be waiting for us around the next bend of our lives. It is because of this uncertainty that we engage in risk management techniques are part of the financial planning process.

Lecture:

This is an excellent time to watch Lecture 13 from the course pack.

Understanding Risk

Risk is defined as uncertainty about future outcomes and events. In finance, risk refers to the unknown events in your life that may affect your financial plan in the future. In order to understand the many different ways that risk can be managed, we need to understand risk at a more fundamental level. There are three concepts that we use to identify the nature and size of financial risks that we face.

1. The first step to managing risk is to identify the sources of risk. An exposure is a source of risk. These exposures can be items we own or activities in which we engage. If you own a car, then that is an exposure because you will have to pay to fix the car if there is an accident. Playing hockey is a risk exposure because you might have to pay for medical attention if you are injured. Any activity or item that could cause loss is an exposure. For example, since your TV might break or get stolen, it represents an exposure. If you didn’t own that TV, then there would be no exposure to the risk of having to replace the TV. Trampolines, cars, and jewelry are also good examples of exposures.

2. After identifying our exposures, we need to estimate our potential perils. Perils are the actual source of loss. They are the negative events that cost you money. Theft, injury, illness, fire, and tornados are examples of perils. A single exposure may face several different perils, and each peril can have a different cost. For example, a car faces the peril of a head on collision on the freeway, but it also faces the peril of being damaged by a hailstorm. Take the time to determine the most expensive peril that each exposure faces.

We also must consider how likely is the peril to occur. Many of the most expensive perils are also the least likely to occur. The peril of getting your house burning down is very unlikely, but extremely severe if it happens to occur! Just because it is unlikely to occur doesn’t mean it isn’t a threat. You need to evaluate both the cost of the loss and the chance it will occur.

3. Hazards are conditions, items, or behaviors that increase the chance that a peril will actually occur. For example, smoking increases the chances of encountering the peril of lung cancer, playing with matches increased the chances of the peril of fire breaking out, and leaving your doors unlocked increases the chances of a the peril of theft occurring. These are all examples of hazards.

Managing Risk

Your objective in identifying exposures, perils, and hazards is to recognize the worst-case scenarios you might face. Good risk management involves protecting against the largest losses first. Smaller losses are less important to protect against. This is called the large-loss principle. Careful consideration of the likelihoods and costs of the perils you face will enable you to recognize your large-loss threats that require the most caution and protection.

We identify the size of a loss by calculating its expected loss. Estimating the expected loss from a particular peril is mathematically very simple. You simply estimate the probability of the peril occurring, the multiply that probability by the expected amount of the loss. For example, if you estimate that you have a 10% chance of getting a parking ticket and the cost of a parking ticket (should you get one) is $50, then the expected loss from the peril of getting a parking ticket is one tenth of 10% * $50 = $5. For another example, suppose you believe that the chance of your home burning down is 1 in 1,000. If the cost to rebuild or repair your home is $250,000, then the expected loss from this peril is one-one thousandth of $250,000, or $250.

The large-loss principle says to worry about the perils with the largest expected loss first!

There are four techniques you can use to handle risk.

1. The most straightforward option is to simple avoid the risk. Risk avoidance involves simply eliminating the exposure. You can avoid the peril of having to repair your car by simply not owning a car. You can avoid the peril of home damage by not owning a home. Avoidance is not always an option. For example, you can't eliminate the peril of lung cancer because the only way to do that is to not have lungs! Some perils, however, can be avoided. For example, the peril of If you face such a peril, consider carefully if the benefits of the exposure. then you should take the time to at least consider avoiding the exposure entirely. If you can’t or don’t want to avoid the risk, you may choose to simply retain the risk.

2. Retaining risk means that you simply accept the risk for what it is and prepare to deal with the uncertainties as best you may. This is not a “do nothing” approach. Rather, to successfully retain risk, you must take steps to be prepared to handle a loss if it occurs. The biggest step you can take is to ensure you have enough money in your emergency fund to pay for the loss if it occurs. You must plan carefully and be proactive to effectively retain large amounts of risk. Retaining risk can be cheaper than other risk management techniques, but it is also considerably more dangerous.

3. You could also try to control losses. Controlling losses means that you lower either the likelihood or the severity of the loss. For example, you might lock the doors of your house to reduce the likelihood of theft, or put valuables in a safe to reduce the severity of a theft, or drive slower to reduce both the likelihood and severity of a car accident. You might drive a less expensive car to reduce the cost of car repairs if they are needed. Controlling losses is an indispensable component of any risk management plan. Failure to control losses at all is simply reckless and will eventually result in catastrophe.

5. The last option you have is to transfer the risk. Transferring risk makes it so that the uncertainty becomes someone else’s problem. A transferred loss is a loss that someone else pays for. The most common way we transfer risk is to purchase insurance. If you get in a car accident, the car insurance company pays most of the cost. This is because you have transferred the risk to them.

You may use any combination of these techniques to handle any given risk. Most risks require you to use a combination of techniques to properly handle them.

Selecting a Risk Management Technique

When should you use which technique?

For losses that are low severity and low frequency, you may want to consider simply retaining the risk. These risks have very small expected losses and are relatively easy to manage in your regular budget and emergency fund. An example of this kind of loss is your smartphone.

Risks with high severity but low frequency are good candidate for risk transfer. The high severity means that if they occur they are likely to be financially devastating. Health risks are good examples of this type of risk. A single medical event, such as a hear attack, can easily cost hundreds of thousands of dollars in medical expenses. This is far too large of a loss for most households to cover with an emergency fund. This makes risk transfer the best solution for this type of risk.

Risks that are low severity but happen frequently, you might retain the risk. However, you also might try very hard to control the loss. If you can make these losses occur less frequently, then you can manage the risk far more easily.

For risks with severe losses that occur frequently, you should always at consider the option of avoiding the risk. If you cannot avoid the loss, then you may consider purchasing insurance. You may also want to control losses as much as possible.

High severity, high frequency risks are often too damaging for a household to manage on their own. This is why many societies have welfare programs in place to help families cope with these expenses.

The Purpose of Insurance

Insurance is for protecting you from declines to your standard of living. It is for protection only, not for making money or getting rich. This idea is embodied in the principle of indemnity. Indemnity means to secure against a loss, not to make a profit. Insurance policies always try to indemnify you. This means that they try to compensate you the amount you lost - no more, no less. Do not expect insurance companies to pay you more than the amount of money you have lost to a peril. Lying and cheating to violate this rule of indemnity is called insurance fraud. This is a very serious crime. The penalties for such attempts may be civil, financial, and in some cases even criminal. To stay out of trouble, just remember; insurance is for reimbursing losses, not for making money!

Definitions:

Risk: uncertainty about future outcomes and events

Exposure: a source of risk

Perils: the actual source of loss

Hazards: conditions, items, or behaviors that increase the chance that a peril will actually occur

Avoiding risk: involves avoiding the exposure

Retaining risk: simply accepting the risk for what it is and preparing to deal with the uncertainties as best you may

Controlling losses: lowering either the frequency of the loss or the severity of the loss

Transferring risk: making the uncertainty becomes someone else’s problem

Insurance: a way of protecting you from declines to your standard of living by transferring risk in exchange for a premium.

Indemnity: to secure against a loss