With financial planning our goal is to minimize the cost of risk. Our primary tool in minimizing this cost is insurance, which transfers risk in exchange for payment (a premium). Insurance is all about managing risk, but how is risk managed? There are three steps in this process.
Step One: Identify the risk.
What is the source of this risk? What are the characteristics? What is the expected frequency and severity? Remember that expected cost = frequency x severity.
Step Two: How much risk am I willing to accept?
Financial considerations are typically the primary factor; how much risk can you afford to accept?
Step Three: How should the remaining risk, the risk that I am not willing to accept, be managed?
How much will each form of risk management cost? Which is most cost-effective? Determine the best way to deal with the remaining risk and monitor the success. Make adjustments if necessary.
While the above are not hard and fast rules since every situation is different, they provide a general idea.