RISK MANAGEMENT
Chapter goals
This chapter will
enable you to :
·
Evaluable
risk management as an overall household approach
·
Distinguish
the types of risk that people are expose to.
·
Demonstrate
how risk modification leads to improved financial management
·
Analize
the central role insurance plays in reducing risk
·
Establish
the common types of insurance avaible .
·
Compare
whole life and term insurance
Risk management in practical
terms
We have said that , in theory, risk is probability
of an outcome different from the one
expected . outcomes above and below
expectations are considered risky. In practice, we have a different definition
.in practice , we are only concerned with outcomes that are below expectations
: these are the outcomes that produce
losses .therefore,we can view risk in practice as the probability of a
loss or outcome that is below expectations.
People are exposed to risk in every aspec of their
lives. Risk management in practical term can be defined as the process by which
we identify risks and control them so that we are abke to achieve individual
goals.notice we use the word control .as we’ve said,we cannot hope to eliminate
risk entirely,we can only attempt to keep risk within acceptable ranges of
impact on our lives
Risk management process
Risk
management is an erganized process that looks at practices in broad term and
works its way to the most speficic details.
The
six steps f this process are outlined in figure 10 .1and then discussed
individually
Develop
objectives
Objectives
determine the scope of ther risk management process . do you want to select one
area examine all household risks ?
Establish
exposures
Each
area of household assets has its own risk. We can separate them intofinancial
and nonfinancial asset. Nonfinancial asset may, in trun, be segregated into
human-related asset and real asset. A risk that we are concerned about for
planning purpose is one that can significantly affect assets or cash flows.
Identify available risk
management tools
There
are many techniques available to you in managing the overall risk of the
househould.
Common
risk management approaches are discussed below.
Avoid
risk under the
avoid method, you seek to eliminate exposure to risk. If thereis risk that you
will be injured if you cross the street on a red light, you may wait until the
light is green.
Reduce
risk when you reduce risk, is it not eliminated; it is lessened. When you
exercise andeat the right foods, you reduce the risk of becoming ill.
Reduce
potential loss when you reduce potential loss, you lessen the damage should
a loss occur. Wearing seat belt serves this function in the event an accident
takes place.
Retain
risk you retain risk when you reject
the possibility of reducing or eliminating risk but instead decide to absorb
the potential loss yourself. Of course, in some cases, you are forced to retain
risk because it is uninsurable. For example, there is nodirect insurance
against a deteriorating neighborhood and its effect in the value of your house.
You have to consider shifting homes.
Deversify
with this method, assets diversified
so that the impact of an unfavorable outcome for any one asset is reduced.
You diversify when you allocate your marketable assets to many different
categories-domestic and international stock including small, medium, and
larger-sized companies. When you get merried and both you and your spouse work,
you are diversifying assets.
Transfer
risk when you takes the possibility of loss and give it to someone else,
you transfer risk. A typical example of transferring risk is when you purchase
a homeowner’s policy that insures againt the loss of your home being destroyed
by a fire. You have transferred your risk to the insurance company.
Sharing
risk when you share risk,the transfer of risk is not always a full one.
Some risk may be retained, thereby limiting, thoughnot eliminating, a risk. For
example, when you some riskand retain a part of it, we call that sharing risk.
Other
methods of handling risk there are host of other methods to aid in altering
risk. Many are utilized principally for marketable securities and in
businesses. They include options, futures, and swaps.
Match appropriate risk management
tools to exposure
Different
exposures call for separate risk management tols. You would literally buy
insurance against the risk of job obsolescence.instead, you might go for
additional training, each major area of the household portfolio-human-related
assets, real assets, and financial assets-has its own grouping of methods
managing them.
Implement
Implement
is taking the action step. Sometimes people have difficulty implementing a risk
management strategy. They procrasrinate in beginning new personal practices or
purchasing an insurance policy. Stting an implementation plan with specific
dates to accomplish takes can help.
Review
Risk
management exposure can shange. For ecample, a policy for household possessions
may become insufficient over time because of inflation and new aacquisitions.
It is a good idea to review ecposure at least once a year.
Insurance
Insurance
is a method of transferring risk. The process by which an insurance company
agrees to assume the risk in return for a projected profit is called insurance underwriting.
Insurance theory and practice
Insurance
is one of the principal tools used to modify portfolio risk. But why insurance
products are not fully efficient in a financial sense.
Overhead
costs
Insurance
companies have overhead costs to maintain and grow their businesses, pay out
claims, and earn a profit. These costs are built into the price of insurance
policies.
Incomplete
information
A practical matter, insurance companies hane
incomplete information; in other word, they may have less knowledge about
future claims than the applicant for an insurance policy. Specifically, less
healthy applicants may pass insurance company screens. If the insurance company
knew of their healthy problems, it would reject them.
Search costs
These
are costs that the person desiring to be insured undertakes to find out which
policy is best. Most of the costs involve hours spent in selecting and
processing the policy. In according to economic theory,this search cost
.self-insuring eliminates this cost and chould allow the person to select
either higher income through additional
work or extra leisure time as alternative .
Behavioral factors
Some academic evidence suggests that humans
may not always act efficienly in risk management activities . for example, one
study has shown that people are underinsured for flood risk despite large goverment
subsidiesfor that insurance . there is evidence that people prefer to have low
deductibles instead of taking high
deductibles ,even when they are given
economic incentive to do so . they may pefer to insure againt small losses that
have high probabilities of occurring and
not larger losses whith low probabilities of occurring. They tend to
overestimate low probability losses and underastimates high probability losses
. the way the risks are presented to people seems to matter.
Types of insuranace policies
As
we discussed insurance is used to shift part or all of the risk for certain
exposures . the three major types of policies are private personal , private
property , and government insurance .
Insurance providers
There are
three major types of providers of insurance to individuals: the government , private
insurance companies through group policies offered institutionally, and private
insurance companies through individual policies offered by independent agent. Goverement
policies tend to concentrate in items with widespread exposure by cross-sections
or individual strata of society. The cost of these policies tends to be low or they
are provided free or change as social insurance that is part of the “safety net”.
Social security may be an exception to low cost because it has income
redistribution motive.
Group policies
offered by private insurance companies to independent to businesses for their
employees, but also provided by insurance companies for fraternal or other organizations,
often percent the cheapest form of goverement contracts. Independent businesses
can take advantage of low marketing costs, benefit from mass-volume efficiency,
and may assist with screening and administrative costs, thereby further
reducing premiums.
Individual
polices bought directly from independent agents of insurance companies are
often the most expensive but also the most flexible. Buyers can select the
individual company and policy with the terms they prefer, which often will not
be available in a group policy.
Analyzing an insurance company
An important
factor in selecting among insurance policies is the quality of the company that
offers the policy. The criteria to consider are
Financial
strength
How secure
is the insurer’s financial condition? Best, standart and poor’s, moody’s, and
other agencies avaluate and rate an insurer’s finances. The ratings range from
AAA to C with commentsurate declines in your confidence in the insurance
company’s promise to reimburse you for losses you may have in the future.
Good
operating sense
Good operating
sense contributes to financial strength. It measures how wise the company is in
selecting risks it is willing to underwrite and how efficient it is in running
its business and processing its claims. A more efficient company often has more
competitive price.
Service
Important
questions to ask are “how good is the company’s service?” and “does it pay out
promptly and fairly on claims submitted?”
Price
as in
other forms of merchandise offered to the consumer, price often varies by
company polisy. Price should be compared with quality to obtain the best value.
When using price as a criterion, pay particular attention to financial strength.
Other
considerations
Factors such as the size of the company, how long
ithas been in business, specialization, and so on, may enter into
consideration. In addition, there is the question of location. Some states
provide unofficial help for companies in financial difficulty in merging with
stronger companies so that they don’t default on their policies.
Insurance as an asset
Insurance
is commonly regarded as an expense, an appropriate designation. For certain
uses, it can be viewed sa an asset. This designation comes about because owning
insurance can actually lead to higher net revenues.
Sumber “text book risk management”
