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Risk Management in Your Personal Financial Plan

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RiskManagementinYourPersonalFinancialPlan
JenPiesonTuesday,December04,2012

Written By: Tom Gates

Risk is a fact of life. We might not like it, but its not going away. There are two types of risk:

Pure Risk: We can only lose if an event occurs; for example, the risk of a ood doing damage to
your house in any given year. Either the house is damaged by ood, or it is not. This type of risk
is generally insurable.

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Speculative Risk: We can lose, gain, or stay the same. Gambling is an example of speculative risk.

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You can win money, lose money, or come out even. This type of risk is NOT traditionally
insurable (although there are sometimes ways to hedge these risks, like diversifying your
investment portfolio).

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In this article I will focus on risks we face outside of the investment world. Risks within the
investment world we will cover on another day. The primary goal of personal Risk Management
(RM) is to protect ones goals, dreams, treasure and personal well-being from those "what ifs" that
might become "what now"?

RM is not a static process. The risks that we face and the strategies that we use to protect ourselves
change as our personal nancial circumstances change. Where we are in our nancial lifecycle
matters, too. For example, during our early earning years we tend to have many commitments;
kids, mortgages and car loans, and relatively few nancial assets. Premature death and disability
are key risks to our goals so we look at life and disability insurance to offset those risks. On the
other side of the coin, during our retirement years, we tend to have fewer nancial commitments
and less reliance on earned income but more nancial assets and cash ow from pensions or social
security. Healthcare, assisted living and liability issues are key risks to our lifestyle and legacy
goals then, so we look at Medigap, long-term care and personal umbrella insurance policies to
offset those risks.
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Risk Management in Your Personal Financial Plan

The RM process involves three steps:

(1) The cause and nature of the risk should be identied. For example: Premature Death, which
leaves the family to cope with lack of income to pay debts and living expenses.

(2) A determination should be made of how much risk a person should be willing to retain. In the
case of a homeowners policy, how much of a deductible should be assumed? Or, if you live in the
mountains, should events such as earthquake or ood be covered, since they are unlikely to occur?

(3) Determine how to handle risk NOT retained. A crucial RM factor is to balance the expenditure
of insurance premium dollars against the risks that present the highest negative impact to the
individuals personal nancial plan. We could insure ourselves from almost any risk but go broke
paying the premiums.
There are ve distinct methods, or strategies of dealing with risk:
Risk avoidance: Avoid those high risk activities in your life that, should they happen, would be
catastrophic to your personal nancial plan. Examples of these activities would be speeding,
dangerous sports, smoking, etc.

Risk retention: To personally assume the risk, in essence self-insuring. In this case the risk must
not impose a substantial nancial or non-nancial threat to you. For example, "I do not insure my
life because I have no debts or obligations," or "I forego long-term care insurance because I
believe I have enough in nancial assets and cash ow to pay out-of-pocket for this type of
medical care.

Risk reduction: There are two sub strategies to this method: Loss Prevention and Control, for
example: use of re and burglar alarms, air bags, and smoking and weight control programs. Risk
reduction can also involve minimizing risk by using an insurance company that uses the law of
large numbers to maintain their solvency.

Risk sharing: In this strategy one assumes a limited degree of manageable risk and transfers the
balance of the risk to one or more organizations. For example, I choose a high deductible health
plan that would require me to pay the rst $5,000 of any major health bills, but would then pick up
100% of the cost after that. This risk sharing agreement allows me to cut my monthly insurance
premiums by 40%. I can cover the $5,000 in risk and hope that over the long run my reduction in
premiums justies the risk of having to pay $5,000 out-of-pocket.

Risk transfer: I transfer risk completely to a third party in consideration of an insurance premium.
Life, disability, and liability risks are often dealt with in this way.

These strategies can be used to design a RM foundation balancing premium outows with the
impact of a risk based event:
Sky Diving - High Frequency, Loss Likely. Avoid this risk. (Dont sky dive.)
Disability - Low Frequency, Loss Likely. Transfer or Share this risk. (Get disability insurance to
replace part of your income.)
Flu - High Frequency, Loss NOT Likely. Reduce this risk. (Have medical insurance, but also wash
your hands often.)
Vacation Insurance - Low Frequency, Loss NOT Likely. Retain or Share this risk. (Consider
vacation insurance on a case-by-case basis.)
Getting assistance with risk management analysis can often be problematic. Insurance salespeople
are the typical risk consultants available today but because they are compensated by product and
insurance sales commissions or are biased to their respective areas of risk expertise, they can often
cloud what is in the best interest of the overall personal nancial plan.
A Fee-Only nancial advisor is dedicated to providing you with the most comprehensive and
objective risk management analysis and keeping it in sync with any changes in your nancial
situation or personal nancial plan.
Written By: Tom Gates
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Risk Management in Your Personal Financial Plan

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