An Introduction to Insurance and Risk Management – Part 1
Wouldn’t you love to be a risk manager? It sounds like a job for the man or woman who gets great joy from being a party pooper. I suppose that might be true in some circumstances, but risk management plays an important role in our lives. In fact, we are all risk managers in one way or another.
Risk management is a broader term than insurance. When we think about risk, we are concerned that some event may cause us or our loved ones harm or loss. If you own a home, you probably have property insurance, so that were there to be a fire, for example, you could receive an insurance payout and rebuild your home. Car insurance covers you if you are in a collision and your car needs to be repaired or replaced. In a previous post, I wrote about asset allocation. This is also a risk management strategy because thoughtfully diversifying your investment portfolio reduces the risk of investment losses.
There are four basic approaches to risk.
There are some activities that we might want to do for the thrill and the challenge, but that present, at least in this cautious man’s perspective, an unreasonable risk. Perhaps it is best to simply avoid the risk. This is called Risk Avoidance. An example that quickly comes to mind is the “Running of the Bulls” in Pamplona, Spain. Someone may tell me that with careful preparation the danger can be largely avoided. I’ll just say no thank you.
Be Less Likely to Lose
You can’t always avoid risk completely. Sometimes people are forced to stay inside because of poor health, but few people choose to stay inside in order to avoid every possible risk they can imagine. I live in a neighbourhood that is not far from a busy street. It can be somewhat risky to cross the street with all the traffic that is going on. However, I reduce the risk of getting hit by crossing at an intersection where there are lights. This is Risk Reduction. Another thing people do is to change their lifestyle to avoid certain health risks, for example by reducing their sugar intake in order to avoid obesity and the associated diseases.
Share the Loss
Risk Transfer is what insurance is all about. In exchange for paying a premium, your risk of loss will be transferred from yourself to an insurance company, which, because they take in money from all their policy holders, is able to spread those risks around. The insurance company can handle the risks better than you or I can. Really, this is the reason we have insurance companies.
Insurance is all about risk sharing; it is about reducing your individual risk by pooling it together with others. Insurance companies crunch the numbers, predict the likelihood of loss, and charge a premium for taking your risk onto themselves. Insurance makes sense when the potential loss could be ruinously difficult to bear but the likelihood of loss is relatively small.
Insurance companies don’t necessarily take on all the risk themselves. For example:
- Establishing a deductible on your car insurance;
- Excluding certain activities from coverage – an avid skydiver may have no insurance coverage if death occurred while skydiving;
- charging higher premiums for greater risks, the classic example being life insurance for the smoker vs. the non-smoker.
The Loss is On Me
Sometimes it makes more sense to simply accept the risk and not try to insure it. A common example of this stance, known as Risk Retention, is when you buy a new TV at a big box store and you are offered an extended warranty for two or three years. How likely is it that your new TV will fail over the period of the extended warranty? Often, it doesn’t make sense to pay for that extra insurance.
In my next post I will look at a specific example of risk management – life insurance.
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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, accounting or legal decisions.