Risk Management: Because Insurance Can’t Cover Everything
When we think of managing risk, we usually think about insurance. We buy life insurance to protect our family against the risk of premature death. We buy disability insurance to protect ourselves against the risk of a lengthy loss of income due to a disability. We buy home insurance to protect ourselves against the risk of damage or destruction of our home due to fire or some other calamity. We buy car insurance to protect ourselves against the risk of an accident and the subsequent need to spend money on repairing or buying a new vehicle. We buy liability insurance attached to our homes and our vehicles to protect against the risks of being found financially responsible for some form of associated injury. I could go on but those cover the basics.
There are other risks that we may face that cannot be addressed by a contract with an insurance company. In other words, we “retain” the risk, or at least part of it, and it is up to us to eliminate, or at least mitigate the risk.
An Emergency Fund
You can call it a Reserve Fund or a Contingency Fund if you prefer, but the point is to have some money set aside to cover unexpected expenses. When it comes to formal forms of insurance, we pay a premium to cover the cost of a relatively rare event that would be catastrophic if it were to occur. It can feel like a bit of a waste of money, though, if you wind up never using it. With an emergency fund, however, the money remains in your possession until it is spent. The expenses are usually not catastrophically large. However, if you do not have the cash immediately available, you may find yourself paying high interest rates because you have had no choice but to put the expense on your credit card.
What is a suitable emergency fund? The usual guideline is to set aside three to six months of living expenses for your household. What are some factors to consider when deciding whether you need a smaller amount or a larger amount?
Debt
If you are in a situation where you need to get to your place of work by using a car, perhaps because there is no viable public transit option, and you have borrowed money to own that car, you do not want to be without it or a substitute loaner car if it suddenly needs repairs. If the debt is a mortgage, no doubt most people will feel even more incentivized to make sure the payments keep on being made regardless of circumstances. These kinds of debts argue for pushing the guideline toward the six-month range rather than a mere three months. If, on the other hand, you don’t have debt, this relieves you of the need to set aside a larger sum.
A House
Regardless of whether you have a mortgage, owning a house requires regular spending for repairs and maintenance. Some of these can be predicted; others are surprising. The nightmare scenario in Canada is to have your furnace stop working on the coldest night of the year. Again, owning a home where potential needs can be varied and expensive argues for emergency savings toward the longer end of the spectrum. However, if you are a tenant, the responsibility for maintenance and repairs lies with the property owner, lessening your obligations.
Spouse and/or Children
An argument can be made that a single person might need a larger emergency fund than someone with a spouse/partner because there is the potential for a couple to have larger sums of money or at least different sources versus single persons who have only themselves to rely on. However, it is generally the case that single persons have fewer fixed financial obligations, and also have greater leeway in terms of their ability to adjust their lifestyle to accommodate an unanticipated expense.
Those with a spouse or children have people beyond themselves who are dependent on them for their income. Given the larger number of people in the household, fixed expenses are also likely to be higher. The recovery period following an unanticipated expense will likely take longer as well given the financial obligations a household has, and those obligations can extend into healthcare-related costs and education. Furthermore, families may have less ability to relocate. It’s one thing for an “unattached” person to relocate for better opportunities. For a couple, relocating for the sake of one spouse may mean the other spouse has to give up a job. In addition, if there are children involved, there may be a strong desire between the parents not to disrupt their lives. Labour mobility may be the ideal for economists, but it is not always the case for households.
When compared, then, a single person is more likely to be safeguarded against an emergency with funds set aside for three months of living expenses whereas a larger household will probably want to set a goal closer to six months to manage the additional risks and limitations.
Variable Income
At the safer end of the spectrum is the person well-established in a salaried job. At the riskier end are those who are self-employed, who rely on commissions for their income, where there tends to be high staff turnover, or where the industry they are employed in tends to be highly cyclical. While the former may have steady but unspectacular income, they can usually get away with a smaller emergency fund. On the other hand, people with more irregular income may have the opportunity for a windfall but may also find themselves without any income at all for extended periods. In that case, in addition to an emergency fund, such persons may need an even larger reserve to smooth out coverage of their spending.
Skills Development
As implied in the discussion about variable income, above, disruptions to employment income are a meaningful risk for many. One way to address this issue is to make oneself employable regardless of the circumstances of one’s current role. That could involve ongoing training or professional development, achieving certifications in fields that are either related to your current position or that could lead to work in a new field. My education and career were primarily in theology and religion until my mid-40s. An interest in personal finance prompted me to study for the Canadian Securities Course, which served me well when, a few years later, I was forced to recognize the limits of my ability to serve professionally in a church-related role and needed to find a new position.
Diversifying Investments
While insurance is all about managing or mitigating risk, investing is usually thought of as risk-seeking behaviour. One way to mitigate investment risk, though, is to diversify your investments. Don’t focus only on bank stocks, the stocks of companies that pay high dividends, only on Canadian stocks, or at the opposite end of the risk spectrum, focussing only on Guaranteed Investment Certificates (GICs). By narrowing the range of available investments, the investor is taking on risks that are unlikely to be compensated. Why? Because “predicting is hard, especially about the future.” Since very few investors, even the most skilled professionals, can reliably predict investment outcomes, the wiser choice for most of us is to invest broadly and simply try to capture the returns of the global securities markets.
Health and Wellness
As someone who has lived with chronic kidney disease since I was 25 and is now experiencing its successful treatment for nearly eight years via a kidney transplant, this risk management category hits home. Not every disease can be prevented by a healthy lifestyle – cystic fibrosis, rheumatoid arthritis, certain cancers, etc. – but many diseases can be thwarted, or their severity limited, through exercise, diet, and preventative healthcare.
Identity Theft and Cybersecurity
I work with my clients online. I back up the daily activities recorded on my computer to an external drive. The latest software I use requires two-factor authentication. Since I am an advice-only financial planner, there is only a limited amount of personal information I need to know. For example, I don’t need to know a last name or even a Social Insurance Number. Clients upload their documents via a portal that secures the documents while in transit and “at rest.”
Unfortunately, not every platform or business provides an appropriate level of security. Furthermore, we should be sufficiently aware to recognize that there are people out there who prey on those who do not take steps to protect themselves. Things like complex passwords or password managers can go a long way to protecting you, as can simple things like regularly monitoring your financial accounts to see if anything unusual has occurred.
Spending Habits
Borrowing is a necessity for most people when they make large purchases. However, it is an aspect of risk management to limit your debt to a level you can repay. One of the factors that financial analysts use to assess the appropriateness of investing in a given company is to see how the company’s debt compares to the debt of other companies in the same industry. All else equal, a company with less debt will be viewed more favourably because it can weather an economic downturn easier than a deeply indebted company. The same can be said for households. We may not be the object of a financial pro’s analysis, but careful management of our spending can put us in good stead when confronted with an unanticipated risk.
By developing a well-thought-out risk management strategy that goes beyond insurance, households can improve their resilience in the face of unexpected risk. Insurance is important and valuable for almost all people, but with prudent additional risk management strategies that go beyond the realm of insurance, a hardier foundation for personal and household security can be established.
What are some non-insurable risk management strategies that you use to protect yourself against unnecessary losses?
This is the 236th blog post for Russ Writes, first published on 2024-02-19
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.