risk management

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.

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