What Is Risk and How Can We Reduce the Costs of Risk?
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What Is Risk and How Can We Reduce the Costs of Risk?
Risk is the possibility of loss. Sometimes the loss is trivial, while at other times it may cause major personal and financial hardship. Risk is often unpredictable. It can come in many forms, but the results are always the same: loss of money. It might be due to loss of family income from death, disability, illness, legal action, or other circumstances beyond your control. There is no way to eliminate all risk, but there are ways to avoid, minimize, or protect yourself and your family from risk. When risk is low, or the cost is not too high, it is easy to assume risk yourself. When it is too costly to assume risk, you need other ways to manage it. Insurance provides a convenient way to manage financial loss due to catastrophic risk.
Things To Know
- When it is too costly to assume risk, you need other ways to manage it.
- When planning your financial goals, you need to consider the risks to your income and investments.
How to manage risk
You can manage risk in four ways:
- Assume risk
- Avoid risk
- Share risk
- Transfer risk to someone else
Assuming risk
When you assume risk, you do nothing to minimize the financial impact of loss should a hazard occur. For example, you don’t buy fire or flood insurance on your home or you don’t have life, disability, or health insurance coverage. Should a risk occur, you must pay the full cost of the loss out of your own money and other assets. This can adversely affect your financial goals for you and your family.
Avoiding risk
Avoiding risk may not be easy, but there are ways to lower risk management costs by doing so. Risk avoidance can lower the financial cost of risk, which is why insurance premiums are lower for persons and businesses that take measures to lower risk. For example, automobile insurance premiums are lower for drivers with good driving records (no accidents and no cited violations of driving laws), and non-smokers pay lower medical insurance and life insurance premiums than smokers do.
Sharing risk
Sharing risk divides the cost of risk among those who participate. In a household where there are two earners, although the family income might be reduced should one earner lose his or her income, all is not lost, especially if only one earner’s income is necessary to achieve the financial goals. Some insurance policies allow you to share the risks with the insurer in order to get a lower premium. If you can assume a certain amount of financial risk, then the insurance premium on the balance of the risk will be lower. For example, some automobile policies have lower premiums if you are willing to take responsibility for the first $500 of liability, known as a deductible. Medical insurance premiums can also be lowered if you have higher co-payments.
Transferring risk
Finally, for those who cannot tolerate any financial risk, risk can be transferred to someone else, usually an insurance company, who assumes full responsibility for it. Of course, this method of risk management has the highest premiums to pay. An insurer will pay the costs of loss to an insured in consideration of a fee called a premium, which is usually a very small fraction of the benefits to be paid.
How risk is perceived
What counts as risk is different things to different people. Risk perception changes as you age. When you’re young, your impulse control is not as developed as it is when you’re older. This means you’re likely to try risky behavior. As you get older and you improve at assessing risk, you can evaluate risks more carefully.
Many other factors influence how we perceive risk. Social status and wealth are two of them. Low-income people have less of a financial cushion, so they may avoid risks. They may see risk as a threat. Insurance is more expensive for them. Because of this, they may take fewer risks in life; when they do take risks, it may be more out of necessity. Higher-income people can afford to take risks. They have more access to education and financial help. They can afford to pay more for insurance coverage. They may see risk as an opportunity more than a threat.
All of these factors and more will affect how you manage the risks in your life.
One last thought
When planning your financial goals, you need to consider the risks to your income and investments. Prudent investors evaluate their risk tolerance and make appropriate investments to assure that they will achieve their goals despite the potential risks that may befall them.
