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What are the Steps in Managing Risk?

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.

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Ways of Managing Risk

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 utilized simultaneously.

Risk Avoidance (elimination of risk)

Completely avoiding an activity that poses a potential risk. While attractive, this is not always practical. By avoiding risk we forfeit potential gains, be it in life, in business or in with investments.

Risk Transfer (insuring against risk)

Most commonly, this is to buy an insurance policy. The risk is transferred to a third-party entity (in most cases an insurance company). To be more clear, the financial risk is transferred to a third-party. For example, a homeowner’s insurance policy does not transfer the risk of a house fire to the insurance company, it only transfers the financial risk. A house fire is still just as likely as before. Risk sharing is also a type of risk transfer. For example, members assume a smaller amount of risk by transferring and sharing the remainder of risk with the group.

Risk Reduction (mitigating risk)

This is the idea of reducing the extent or possibility of a loss. This can be done by increasing precautions or limiting the amount of risky activity. For example, installing a security alarm, smoke detectors, wearing a seat belt or wearing a helmet are ways of employing risk reduction. Diversification of assets and hedging are forms of risk reduction with investments. Investments in information are a way of mitigating risk because you are better informed, thus reducing the uncertainty. Another way of employing risk reduction is the safety in numbers approach. When discussing risk transfer, we spoke briefly about risk sharing. The larger the number of people sharing risk, the less severe the shared effects will be. Statistically, only a small number of individuals in the group will experience an unfortunate event. Insurance companies exist based on this concept.

Risk Retention (accepting risk)

Risk retention simply involves accepting the risk. Even if the risk is mitigated, if it is not avoided or transferred, it is retained. Retention is effective for small risks that do not pose any significant financial threat. The financial status of the family or individual will determine the acceptability of a risk. A couple of examples of risk retention: A billionaire may not have to worry about insuring his car. An individual may not be able to afford or obtain health insurance. Both individuals are retaining risk, one is because they’re able to, the other is because they have to.  Risk retention augments risk transfer through  deductibles.  With a deductible, we retain or ‘self-insure’ small, frequent occurrences and only utilize insurance for needs over a particular dollar threshold, our deductible limit.

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Introduction to Risk

Risk is uncertainty.  Risk is the variability around an expected outcome. The larger the variability, the higher the uncertainty, the larger the risk. Risk is pervasive. Most activities involve some sort of risk. Accepting risk involves nothing more than a cost-benefit analysis. We choose to accept risk because we see the benefits as outweighing the cost.

Adverse decisions in accepting risk can be due to a number of things including influence of substances, lack of information, lack of understanding, lack of judgment or the existence of emotional factors.

We must accept some risk.  Risk is expensive. The purpose of risk management is to minimize this cost. What will give us the most value for our dollar in the cost benefit analysis of risk?  This is the goal of risk management.

Our aim in financial planning is to manage individual, personal risks. Personal risks involve risk exposures that reduce our individual wealth. These include: liability risk, income risk, longevity risk, asset risk and medical risk.

Below are a description of risks with common ways of managing them.  The primary purpose is to provide a brief description and show you where to find more information on the managing of this particular risk.  There are multiple ways of managing most risks, risk transfer is one way.  Insurance is a form of risk transfer.

Liability Risk:

Risk of being sued for damages to others.  Managed through liability insurance.

Income Risk:

Losing job, losing family breadwinner, losing ability to work (i.e. disability).  Managed through life insurance, disability insurance, social programs, etc..

Longevity Risk:

Outliving finances.  Covered through proper retirement planning and effective use of assets during the lifetime.

Asset Risk:

Losses to monetary and physical assets (house, car, investments, retirement).  Protection of physical assets are covered under property insurance, i.e. renter’s, homeowner’s, or auto insurance.

Medical/Health Risk:

High medical costs.  Covered through health insurance.

These are the risks that we manage through financial planning.  Business risks have similarities, but are also very different.  In addition to the above, there are many ways to reduce risk in both frequency and severity.

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Homeowners Insurance Policies: Coverage A

Coverage A, Dwelling, attached structures coverage:

Dwelling and attached structures are included. Structures under construction as well as building materials located on the property are also covered. Though some business may take place, the dwelling must primarily serve as a residence. If liberal amounts of business take place, a business policy should be considered in order to ensure full coverage or property and equipment.

Applicable provisions:
Co-insurance clause:

In order receive full replacement value (like kind replacement cost) for damage to the house, dwelling coverage must be equal to at least 80% of the structure’s full replacement value not including the value of the lot. For example, a $100,000 structure must be insured for at least $80,000. If coverage is adequate, the insured will receive like kind replacement cost (i.e. the insurer will pay for like kind construction) less the deductible up to the policy limit. If coverage is inadequate (i.e. less than 80% of full value), then the insurer will pay less than the full replacement cost. Most insurers will not issue policies for less than 80% of the full replacement value of the house.

Guaranteed replacement cost:

For a higher premium a guaranteed replacement cost option also exists that allows the insured to receive full replacement value even if it exceeds the policy limit. Though the previous sentence is in reference to structures, personal property (coverage C) also benefits from guaranteed replacement cost as policyholders will receive replacement cost for losses as opposed to actual cash value which is typically less due to depreciation. Some limitations and rules apply to the guaranteed replacement cost option. For example, sometimes percentage limits exist on the maximum replacement value (i.e. 150% of policy limit) and dwelling coverage must equal 100% of full replacement cost, rising as the value of the home rises. HO-5 policies automatically include guaranteed replacement cost for coverage A (dwelling, attached structures), B (other structures), and C (personal property). Keep in mind that despite the “guaranteed replacement cost” provision, policy limits (maximum caps on indemnity paid) exist. Sometimes instead of guaranteed replacement cost companies offer extended replacement cost in order to protect themselves. Be sure you fully understand your particular policy.

Functional replacement cost:

As opposed to like kind replacement, cheaper materials are used that serve the same purpose. Functional replacement cost would be used when, due to depreciation or other factors, actual replacement costs of materials or craftsmanship exceed market value of the property by a substantial margin. By agreeing to settle losses using functional replacement cost or cash value, owners of homes in this category can obtain coverage more easily and for more reasonable premiums.

Inflation guard endorsement:

An inflation guard endorsement can be added to ensure that insurance coverage keeps pace with the increasing value of the home and adequate insurance is maintained. This will help provide protection against falling below the 80% threshold and receiving less than full replacement value. Note that inflation guard can also be purchased for floater policies in order to keep pace with items that increase in value (e.g. collectibles).

The following may not be applicable in all areas of the country:
Insurance against robbery and burglary:

This option exists for individuals in certain states. Individuals living in high-risk conditions may consider this option.

Earthquake and Flood insurance:

These additional coverages are excluded from basic homeowners policies, but can be added. Earthquake insurance is usually written as an endorsement and is easier to obtain than flood insurance. In order to add flood insurance certain conditions must be satisfied in reference to local flood control. Flood insurance is provided by the National Flood Insurance Program (government program) but can be purchased through some private insurance companies.

Home-business endorsement:

Adds increased coverage and liability for business related incidents and damages. Most basic policies have limited coverage on home office equipment and exclusions on business related liabilities, for example.

Sewer, storm drain backup coverage:

A basic policy may not cover damages caused by a backed up sewer.

Beach and windstorm plans:

Available in certain coastal states where threat of storms and hurricanes is high and insurance is difficult to acquire or afford, primarily Florida. Coverage in this category is similar coverage in other residual insurance markets.

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Homeowners Insurance Policies: Coverage B

Coverage B, Other structures, separated structures:

Covers all detached structures, i.e. storage shed, detached garage, fence, gazebo, etc. Under HO3, combined coverage for all detached structures is 10% of dwelling coverage, but the option to raise this limit is available via an endorsement.

Applicable provisions:
Co-insurance clause:

In order receive full replacement value (like kind replacement cost) for damage to the house, dwelling coverage must be equal to at least 80% of the structure’s full replacement value not including the value of the lot. For example, a $100,000 structure must be insured for at least $80,000. If coverage is adequate, the insured will receive like kind replacement cost (i.e. the insurer will pay for like kind construction) less the deductible up to the policy limit. If coverage is inadequate (i.e. less than 80% of full value), then the insurer will pay less than the full replacement cost. Most insurers will not issue policies for less than 80% of the full replacement value of the house.

Guaranteed replacement cost:

For a higher premium a guaranteed replacement cost option also exists that allows the insured to receive full replacement value even if it exceeds the policy limit. Though the previous sentence is in reference to structures, personal property (coverage C) also benefits from guaranteed replacement cost as policyholders will receive replacement cost for losses as opposed to actual cash value which is typically less due to depreciation. Some limitations and rules apply to the guaranteed replacement cost option. For example, sometimes percentage limits exist on the maximum replacement value (i.e. 150% of policy limit) and dwelling coverage must equal 100% of full replacement cost, rising as the value of the home rises. HO-5 policies automatically include guaranteed replacement cost for coverage A (dwelling, attached structures), B (other structures), and C (personal property). Keep in mind that despite the “guaranteed replacement cost” provision, policy limits (maximum caps on indemnity paid) exist. Sometimes instead of guaranteed replacement cost companies offer extended replacement cost in order to protect themselves. Be sure you fully understand your particular policy.

Inflation guard endorsement:

An inflation guard endorsement can be added to ensure that insurance coverage keeps pace with the increasing value of the home and adequate insurance is maintained. This will help provide protection against falling below the 80% threshold and receiving less than full replacement value. Note that inflation guard can also be purchased for floater policies in order to keep pace with items that increase in value (e.g. collectibles).

Posted By Mays Financial

Homeowners Insurance Policies: Coverage C

Coverage C, Unscheduled personal property:

Covers personal property that is owned and used by the policyholder. Property does not have to be located at residence, but property located at a secondary residence is not covered. Multiple exclusions apply including but not limited to property rented to other individuals, automobiles, sound equipment in an automobile and animals.

In addition to a number of exclusions, dollar limits and sublimits also exist. Sublimits (dollar limits on indemnity paid) generally apply to items with excessive value like jewelry, art, collectibles, expensive clothes, etc. These sublimits are typically very low if you do possess such items, but the purpose is to maintain reasonable premium costs for the average homeowner. Coverage of these items can be increased in two ways: by either raising homeowner coverage as a whole or by adding protection through floater policies. While both ways are feasible, for items of excessive value it is advisable to use a floater policy to ensure full coverage. It is recommended to create an itemized inventory of the items in your home and base your decision for coverage on this list. Additional explanation of floater policies is provided below.

When attempting to recover damages for items from your insurance company most will require some sort of proof of ownership and estimated value (including depreciation) for the property in question. An inventory of personal property is a must have and should be kept in a secure location (i.e. safety deposit box) in case fire or some other event that destroys the residence. A room-by-room video or an itemized list of some sort are a couple of ideas.

Coverage C is trickier than other property coverage under A and B. Be sure that you fully understand your policy, its requirements, inclusions and exclusions. Seek clarification on anything you do not fully understand.

Applicable provisions:
Floater policies:

As mentioned above, sublimits (dollar limits on indemnity paid) apply to items of excessive value like furs, jewelry, firearms, collectibles etc. A personal article policy only provides protection for items named on the policy while a personal property floater covers all items. Under HO3, coverage for personal property is actual cash value replacement (factors in depreciation) and is limited to 50% of dwelling coverage, but the option to raise this limit is available.

Market value:

In basic policies personal property is replaced at actual cash value, which factors in depreciation. In addition to requiring record keeping, indemnity received is often significantly less than what it will cost to replace the item. This stipulation does not apply to the HO-5 policy which automatically includes like-kind replacement (i.e. does not factor in depreciation).

Guaranteed replacement cost:

For a higher premium a guaranteed replacement cost option also exists that allows the insured to receive full replacement value even if it exceeds the policy limit. Though the previous sentence is in reference to structures, personal property (coverage C) also benefits from guaranteed replacement cost as policyholders will receive replacement cost for losses as opposed to actual cash value which is typically less due to depreciation. Some limitations and rules apply to the guaranteed replacement cost option. For example, sometimes percentage limits exist on the maximum replacement value (i.e. 150% of policy limit) and dwelling coverage must equal 100% of full replacement cost, rising as the value of the home rises. HO-5 policies automatically include guaranteed replacement cost for coverage A (dwelling, attached structures), B (other structures), and C (personal property). Keep in mind that despite the “guaranteed replacement cost” provision, policy limits (maximum caps on indemnity paid) exist. Sometimes instead of guaranteed replacement cost companies offer extended replacement cost in order to protect themselves. Be sure you fully understand your particular policy.

Inflation guard endorsement:

An inflation guard endorsement can be added to ensure that insurance coverage keeps pace with the increasing value of the home and adequate insurance is maintained. This will help provide protection against falling below the 80% threshold and receiving less than full replacement value. Note that inflation guard can also be purchased for floater policies in order to keep pace with items that increase in value (e.g. collectibles).