An introduction to the concept of risk, the types of risk and how we manage those various risks through financial planning.
There are four main ways to manage risk: risk avoidance, risk transfer, risk reduction and risk retention. Each is applicable under different circumstances. Some ways of managing risk fall into multiple categories. Multiple ways of managing risk are often used simultaneously.
Insurance is all about managing risk, but how is risk managed? There are three steps in this process.
Risk is expensive. The expense of managing risk is directly correlated with the expected losses. Expected losses can be determined by multiplying the severity (cost) by the frequency. Losses can be both direct or indirect.
Risk aversion is a trait common to most individuals. This is why we buy insurance. Most people must be compensated for accepting additional risk.
Investment risk is something we accept by deciding to invest. Unlike most other kinds of risk, there is no such thing as investment insurance to protect against bad investments. Investment comes with the risk of the loss of the principal sum, but we decide to invest because we believe the benefits (returns) outweigh the risk of losses.
Insolvency risk refers to the possibility that an insurance company is unable to meet its financial obligations.