Back to Basics: Risk Management
If “insurance” comes to mind when you hear “risk management,” you’re not alone!
But did you know that there are other ways to manage risk? In fact, insurance isn’t always the best way. By definition, risk management is planning to avoid or minimize the financial downsides that damage from risks can bring about. And while insurance is one method, there are other ways to handle risks.
The Four Main Ways to Handle Risk
The four most common ways to handle risk include:
1. Avoidance — Steering clear of the risk altogether.
2. Retention — Maintaining responsibility for the risk and its potential outcomes.
3. Reduction — Decreasing the chance of the risk occurring.
4. Transfer — Moving all or a portion of the risk to another party.
To put each risk management method into context, let’s consider a common risk, like vehicle damage due to an auto collision.
▶︎ Risk avoidance would mean leaving your car in the garage and not driving — or not owning a vehicle to begin with.
▶︎ Risk reduction would involve driving less or driving more cautiously to decrease the chances of an accident.
▶︎ Risk retention would mean paying for damage as a result of a collision out of pocket.
▶︎ Risk transfer would mean purchasing auto insurance so the insurance company pays for part of — or most of — the repairs if a collision were to happen.
With multiple options available for managing risk, how do you know which is the best to choose? There’s no single answer, and much will depend on individual circumstances. But understanding risk management basics can help with the decision.
Risk Management Fundamentals
When it comes to managing risk, keep these fundamentals in mind:
- Don’t risk more than you can afford to lose.
- Don’t risk a lot for a little.
- Consider the odds.
It can be helpful to think of it like this:
▶︎ If a risk happens often and associated financial costs are high, it might be best to avoid or reduce that risk. That’s because retaining the risk could be very costly if it were to occur, and an insurer isn’t likely to offer coverage due to the high frequency of the risk occurring.
For example, you have a pool on your property that you enjoy maintaining and using. But neighborhood kids like to sneak in all the time without your permission, and you’re constantly concerned about one of them drowning. Rather than avoiding the risk by filling your beloved pool in, you might install a fence with locks around your pool to reduce or avoid the risk of a child becoming injured.
▶︎ For risks that occur only infrequently and aren’t costly, risk retention can be best. In this case, even though the frequency is low, it may cost more to insure against the risk than it’s worth. And due to the low cost associated with this type of risk, self-insuring may make retention worthwhile.
For example, you own an older car that’s still in great shape, but the cost of comprehensive auto insurance would quickly add up to more than the value of the car in just a few premiums. You don’t plan to stop driving or drive less to avoid or reduce the risk of collision, and you’ve never been in an accident, anyway. So you choose to self-insure and decide you’ll pay for repairs to your own car in the event of an accident.
▶︎ A risk that happens often but that isn’t costly is best managed through risk reduction and retention. The high frequency may make the low costs add up, but it would also likely be more costly to insure than it’s worth. And, again, an insurer isn’t likely to offer coverage due to the high frequency of risk occurring.
For example, you always lose your sunglasses. It happens almost every week, but there’s no use insuring your favorite $20 gas station sunnies — and you’ve decided you won’t avoid the risk of loss by going without them. Instead, you could reduce the risk by using a lanyard that keeps them around your neck while you’re not wearing your sunglasses or simply retain the risk and spend another $20 to replace a lost pair.
▶︎ Risks that happen infrequently but are very costly are usually the best to insure by transferring the risk to another party, like an insurance company. Although the risk is low, it could be severe if retained. And while risk avoidance and reduction could be helpful in limiting the risk, it all goes back to the high cost to the individual if it were to occur.
For example, your house hasn’t flooded before, but it’s on a floodplain and, if it did, it would cost quite a bit to rebuild. You can’t avoid or reduce the risk of flooding, and replacing your home if you were to retain the risk wouldn’t be an ideal use of your finances. So you’d likely purchase flood insurance to protect your finances and repair your home in the event of a flood.
Let’s go back to our hypothetical driver who wants to avoid auto collision damage. They may have no public transportation available where they live and need to drive to work, making risk avoidance impossible and risk reduction illogical.
Being left with risk retention or transfer, they may decide that they’re not willing to retain the risk due to the large amount of damage a vehicle can do — and the high costs that come with damage due to a collision. On top of that, their state of residence likely already requires them to have auto insurance to legally drive.
This could make paying the relatively small insurance premiums required to keep a policy in place seem favorable. Compare that to the potentially endless liability they could be left to deal with if they were to cause damage to someone’s property or injury to another person. In this case, risk transfer via insurance may be a more palatable way to deal with the risk.
But damage due to an auto collision is just one risk to manage. Before making the final decision on whether insurance is the right tool for managing another type of risk, go back to basics and make sure you’re choosing the right insurance tool for the right purpose.
Insurance as a Risk-Management Tool
Insurance Guidance from Fiduciaries Considering insurance as a risk-management tool? At Financial Planning Fort Collins, we don’t sell insurance, and we receive no kickbacks or commissions for recommending policies to our clients. We offer full-time fiduciary financial planning, which includes insurance analysis and guidance. This means that our recommendations are always in the best interests of our clients. To learn more about what we do, you can visit our Comprehensive Services page.
Do use health insurance to protect against large out-of-pocket medical costs. Pair it with risk avoidance and reduction.
Don’t forget that medical bankruptcy is a serious consideration should you decide to retain this risk.
Do use disability insurance to protect from a reduction or loss of income in the event of a disability. Like health insurance, pair it with risk avoidance and reduction. You may also decide to self-insure your risk disability in the short term.
Don’t underestimate the impact of losing the ability to earn income, even for a short period. Due to how detrimental it can be in the long run, you may not want to retain this risk, either.
Do use life insurance to support beneficiaries in the case of your untimely death. If your assets outweigh your liabilities, you may choose to retain and self-insure this one. And, like protecting against illness and disability, you may want to reduce the risk by avoiding situations that could lead to premature death.
Don’t use life insurance as a savings account or because you feel like it’s the right thing to do.
▶︎ Property, Casualty, and Liability insurance
Do transfer risk by using insurance to protect yourself against low-frequency high-severity risks. Risk avoidance and reduction should also come into play to protect your property and to protect yourself from liabilities.
Don’t retain property and liability risks that could be severely detrimental. And don’t forget that liability is potentially limitless.
Want to Learn More About Risk Management? We just released a personal finance module in FPFoCo Academy called “Insurance 101: Risk Management.” It takes a deeper dive into each risk management area with information on how to apply for and use each insurance type. To learn more or to see the other modules available, head to FPFoCo Academy.
Do use these insurance products to protect against the possibility of outliving your money. Given your resources, you may choose to self-insure. Based on potentially high annuity costs, you may want to retain some or all of the risk.
Don’t fail to consider the initial and ongoing fees as well as how inflation could impact annuity payouts. And you may think twice about purchasing an annuity if managing money is one of your strengths or if you work with someone who can make a plan so you don’t outlive your money.
▶︎ Long-term care insurance
Do use it to cover the potentially high costs of skilled nursing care in your later years. Like annuities, and due to prohibitively high costs, you may decide to retain some or all of the risk.
Don’t forget that not everyone needs long-term care. Be choosy when deciding whether to purchase a long-term care policy you may or may not end up using.
If you’re considering purchasing insurance as a risk management tool, remember that many salespeople receive incentives for selling insurance policies. There are many great insurance agents and brokers out there who have your best interests at heart … but not all do. So it’s best to consult with an independent third party who can help you make the best decisions for your situation.
And don’t forget that insurance isn’t your only option. When choosing the right risk management tool for your needs, be sure to consider the rules of risk management, weigh your options for handling the risk in other ways, and, if insurance is the right decision, purchase and use the correct type for its intended purpose.
Not a client yet? See if our ensemble approach is right for you. Head to our Comprehensive Services page to learn more about what we do for our clients.
