Risk is an inherent part of daily life, whether it is hitting someone with your car on the way to work, being diagnosed with a terminal illness or losing your house in a flood. Risk can be defined as an exposure to danger that, as a result, threatens your property/assets, your ability to generate income or your life.
Risk management is the process of identifying these risks and addressing and/or managing them in an appropriate and responsible manner. The four ways of addressing risks are:
- Elimination: Eliminating risk means the total avoidance of certain risky activities or circumstances. For example, you can eliminate the risk of losing your house to a landslide by not buying a house on a hill. Elimination is the simplest, most cost-effective way to manage risk.
- Reduction: Another simple and cost-effective way to reduce risk is by merely changing certain habits or circumstances. An example of reducing your risk is installing smoke detectors in your home. It won’t preclude you from having a house fire, but it does lower the risk of losing your home (and your life) in case of a fire.
- Retention/Acceptance: The risk you retain is the risk you are willing to accept. You may choose not to get collision insurance on an old car because the cost of the insurance premiums is greater than the value of the vehicle. In this case, you are accepting the risk of total loss in case of a car accident.
- Insurance: Insuring against risk provides a great hedge when a risk (or loss) comes to fruition. Quite simply, one can think of this method as pooling your risk with a large group of people and sharing the burden. Is it pricey? Potentially so, however, have you ever heard of someone regretting having insurance in place when the insurance provided a timely financial resource when a loss occurred?
Financial planning provides the perfect platform for the identification and adoption of proper risk management strategies. The establishment of your financial needs and goals in conjunction with an analysis of your current and future cash flows, asset base and wealth transfer strategy(ies) provides vital information and insight. This information can then be used to assign a monetary value to current/future assets, income loss due to disability, asset spend-down due to a long-term care event and income production due to loss of life. At this point, effective risk management strategies can be analyzed and implemented in the most cost-efficient and effective manner.
To summarize, to manage your risk properly, you first must understand what risks exist and the four ways to manage such risks. Comprehensive financial planning provides the foundation you need to decide which risk management strategy would be most effective for each potential risk. After you’ve eliminated, reduced and accepted some risk, in order to protect yourself, your assets and your family, it is vital to insure against the “accepted” risk(s). Always remember, anything worth earning and anyone worth loving is worth protecting.