RISK MANAGEMENT

 

Risk Management is a term most frequently associated with large businesses due to its crucial importance to these corporations. However, risk management activities are just as vital when it comes to personal finances. By definition, risk management is the process of understanding, analyzing and addressing potential risks to ensure objectives are achieved. Sounds simple enough, but why is it so important and what steps can you take in both business and personal finance to mitigate risk? Let us first take a more in-depth look at what constitutes risk management.

TYPES OF RISK

Generally speaking, there are four types of risk, but they are not all mutually exclusive. The first distinction is pure versus speculative risk, and a single event can be one or the other when it comes to these labels, not both. Pure risk is a loss that is only possible if an event actually occurs. For example, your house will either flood or it would not, there is no in between. Pure risk is often insurable. Speculative risk, on the other hand, can result in a gain, loss, or no change at all. An excellent example of this is gambling. And while you can hedge against these risks, they are not generally insurable.

Risk can also be defined as either income risk or expense risk. Just as the name implies, income risk affects your ability to produce an income. Specific examples of income risk include death, loss of work, underemployment, becoming disabled resulting in an inability to work, and, for retirees, outliving your income producing assets.

Expense risk is slightly more complicated but is essentially the idea that you will spend more money than you currently have. This can be voluntary or involuntary. For example, voluntary expense risk would be spending more money than you earn while involuntary expense risk occurs when an emergency forces you to spend money. Often times, an income risk could lead to an expense risk. You may also not be earning enough money to meet your needs, a marker of poverty.

THE RISK MANAGEMENT PROCESS

There are different methods of risk management for the various types of risk, however, the process generally has three specific steps:

Identify the cause and nature of the risk. To use one of our previous examples, your death would leave your family to cope with the lack of income to pay debts and living expenses.

Determine how much risk you are willing to retain. This could be how much deductible you are willing to assume for an insurance policy. Or it could be your choice of a living location and the associated natural disasters of the area. Generally speaking, we all assume some sort of risk every day, it is unavoidable.

Determine how to handle risk not retained.  An important risk management factor is the balancing of insurance expenditures against the risks which present the most significant negative impact on your individual personal financial plan. In theory, we could insure ourselves against almost any risk but go broke paying the premiums.

This process should be followed for any risk you want to plan for and the list of possibilities is nearly endless. As a result, it is important to identify your priorities alongside the risks most likely to come to fruition. This means every individual’s risk management plan will be as unique as their fingerprint. It is also crucial to know that risk management is never a stagnant process, you cannot just set it and forget. You should be reviewing your risk management strategy regularly and assessing whether or not it still satisfies your current needs and objectives.

METHODS OF RISK MANAGEMENT

By employing risk management strategies, we are better equipped to address unpredictable scenarios that can wreak havoc on our personal finances. Risk is not necessarily a bad thing, so long as it is controlled. There are a number of strategies you can use to manage your specific risks. All things considered, there are five distinct strategies when it comes to risk management:

Risk Avoidance.

This entails attempting to avoid high-risk activities which could result in catastrophic impacts on your personal finances. Speeding, extreme sports or smoking are all examples of high-risk activities.

Risk Retention.

In this method, you personally assume all the risk and choose not to mitigate the risk at all. For example, forgoing long-term care insurance because you believe you have enough assets and income to cover the costs should the need arise.

Risk Reduction.

Also known as loss prevention and control, this involves minimizing risk. You can do so by using an insurance company that uses the law of large numbers to maintain their solvency, for example, or by installing smoke alarms in your home.

Risk Sharing.

In this strategy you assume a limited degree of manageable risk and transfer the balance of the risk to one or more organizations. Paying for medical insurance is a perfect example of risk sharing.

Risk Transfer.

As it sounds, in this strategy you completely transfer risk to a third party in consideration of an insurance premium. Life, disability and liability risks are often dealt with in this way.

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