Risk Management Tools

On 06/03/2010, in Investment Concepts, by Jordan Wilson
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Managing risk is extremely important in daily life, as well as in business and investing.

Today we look at five key ways to manage pure risks. These include: avoidance, loss control, retention, non-insurance transfers, insurance.

Risk Avoidance

By avoiding a specific risk, you attempt to eliminate it entirely.

Certain risks are relatively easy to avoid. You can completely avoid the risk of divorce by never getting married. Or you can eliminate the risk of a shark attack by never going into an ocean.

Some risks, like death, cannot be avoided, no matter what actions are taken.

In between these two extremes lie the majority of risks that impact life on a daily basis. These risks can only be avoided provided you are willing to sacrifice much of your existence.

For example, you can eliminate the risk of an automobile accident by not owning a vehicle or ever riding in one. Or you can avoid being mugged on the street by never leaving your home.

For most people, this is not a practical, nor enjoyable, way to manage risk.

Loss Control

Loss control works in two ways.

First, loss prevention is used to to assess the probability of risk. The specific factors that make up a risk are identified. Then actions are taken to eliminate or minimize the key factors.

Second, for those risk factors that cannot be eliminated or minimized, steps are taken to reduce the loss that will be experienced should the risk occur.

Consider the factors involved in an automobile accident. They include: driver skill, driver issues (e.g. intoxication, tiredness, poor eyesight), road-worthiness of the vehicle, road conditions, volume of traffic, the actions of other motorists, etc.

Some loss prevention measures may avoid certain of these factors.

By ensuring that your vehicle is always in excellent condition, you avoid the risk of mechanical problems. If your signal lights are operational, you also eliminate the risk that other drivers cannot determine your intentions. By only driving while sober, you eliminate the risks involved with driving while impaired.

Other risk factors can be reduced but not eliminated.

You could take a driver training course to improve your skills and confidence. When driving in winter conditions, you can ensure that you are using snow tires to assist with the icy roads. You can drive primarily at times when the roads are less congested and not during rush hour.

While these actions help reduce the probability of having an auto accident, they do not entirely eliminate the possibility. This is where loss reduction comes into play.

Realizing that a loss may arise regardless of one’s (reasonable) actions, you can try to minimize the physical, emotional, and monetary damage done.

Driving at a speed appropriate for the conditions is one example. It reduces the odds of an accident (loss prevention), plus it may reduce the actual loss if there is an accident. The financial cost of an accident and the personal injury should be less at lower speeds.

Utilizing a seatbelt is another way to reduce a loss. If you do get into an accident, it is usually safer for those wearing a seatbelt.

Risk Retention

Avoidance and Loss Control are active measures to eliminate or minimize risk.

There are three financial ways to also manage risk.

Risk retention is the managing of risk internally. It is accepted that there is a risk involved in all activities. The company or individual assumes responsibility, in whole or in part, for the potential damage that may occur from the risk.

Risk retention occurs either because alternative risk management tools are not available or they are prohibitively expensive.

For companies that retain many of their own risks, this is called being self-insured.

Because of the high cost and uniqueness of many corporate risks, more and more businesses self-insure.

But individuals also engage in risk retention. In fact, almost everyone reading this post is retaining some risk at this very moment.

Automobile insurance is a good example of risk retention in everyday use. Within the contract, there is usually a deductible (or “excess” in some countries) amount. If it is $300, then you pay for the first $300 on any claim before the insurer covers the remainder. In effect, you have retained the risk for any damage up to $300.

Deductibles are common in medical, dental, and travel insurance as well for individuals.

The other thing to notice with an insurance deductible is that the amount will affect your premiums. If you assume a greater percentage of risk by moving your deductible to $600, your ongoing premiums should decrease. Conversely, if you reduce your deductible to $50, you will see an increase in your premiums.

The greater the risk you retain, the less you should pay to transfer the remaining risk to another party.

Non-insurance Risk Transfers

These transfers typically involve either contracts, hedging activities, or incorporation.

Through a contract, risk may be transferred from one party to another.

For example, you decide to buy a new Mac from Apple. The computer comes with a one year limited warranty as part of the purchase price. Hopefully the life of an Apple computer exceeds one year, especially at the prices Apple charges. So what happens if your computer crashes in the thirteenth month? Or the thirty-third? After twelve months, the risk is all yours.

However, Applecare offers the ability to extend the initial warranty for an additional one or two year period. This contractually shifts the risk of loss through certain damages to Apple for the agreed upon period.

When contractually transferring risk, be sure to know exactly what is in the contract.

A “limited warranty” is so named because it is limited in scope. While you transfer some of the risk to another party, chances are there are key risks that you retain.

For example, the Applecare limited warranty does not cover “damage caused by accident, abuse, misuse, flood, fire, earthquake or other external causes”. Abuse and misuse are nebulous terms that can make filing a successful claim more difficult.

Determine the “exclusions” in any contract before deciding to purchase it. The risks you actually transfer, may not be worth the cost.

Hedging activities may also serve to reduce risk. It is especially useful when addressing portfolio risk. As such, we will consider hedging in much detail at a later date.

Finally, a corporation or limited liability company may be used to reduce personal risk.

For example, you run both a landscaping business and a home building business as separate sole proprietorships (i.e. unincorporated). Landscaping has become a very lucrative business and you earn $100,000 annually from it. Unfortunately, your goal of building window-less houses has not fared as well. In fact, your creditors are taking you to court for unpaid bills.

Since both businesses are sole proprietorships, creditors will be able to attack you personally to get their money. Although your landscaping business is entirely separate, the home building creditors will take those profits.

However, if both businesses had been incorporated, with some exceptions, the creditors of the home building business would be unable to take money from the landscaping company.

Note that this is a simple example. As more individuals incorporate to limit their personal liability, there are additional options for “piercing the corporate veil” and attacking the actual owner for his actions.

At a future point in time, we will look at the pros and cons on the various business entities in detail. But that is a topic for another day.

Insurance

We saved the obvious and most widely used risk management tool for last.

Insurance is used by individuals, businesses, and other organizations to offset many risks.

Premiums are paid to an insurance company. In exchange, the insurer assumes the pure risk and agrees to pay a certain amount should a loss arise.

Like any contract, be certain to know the “exclusions” in any insurance coverage. Often people are surprised by what is not included.

We will look at insurance in greater detail later in the series. As I am certain that almost everyone has dealt with insurance companies on some level, our focus will be more on life related insurance topics.

Which Tools Should You Use?

Whether in your personal life, business management, or investing activities, you will use each of these tools in some combination.

What is the best combination for one person, may not be right for another.

As we discussed with risk in general, each individual’s risk tolerance may differ.

Some extremely risk averse individuals may want low deductibles to cover every problem. These same people will be the ones purchasing extended warranties on products. In exchange for greater peace of mind, they willingly pay a premium for additional protection.

Those who are more risk tolerant will never buy extended warranties and carry high deductibles. In business, they will self-insure. They believe money saved on insurance premiums will more than offset any future losses.

How you combine these tools is completely at your discretion.

How have you already used these tools in your life?

Your views and actions will help you to understand your own personal level of risk tolerance.

It is important for investors to learn about themselves. How one invests is usually a function of one’s risk tolerance.

We will look at investor risk profiles in the near future.

1 Response » to “Risk Management Tools”

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