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- Chapter 10
Risk Management
1
- Chapter Goals
Evaluate risk management as an overall household
approach.
Distinguish the types of risk that people are exposed
to.
Demonstrate how risk modification leads to improved
financial management.
Analyze the central role insurance plays in reducing
risk.
Establish the common types of insurance available.
Compare whole life and term insurance.
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- Risk Management Theory
Risk management in theory can be viewed as the
study of methods for controlling portfolio risk.
The goal is to have the highest quality of life
possible, given your tolerance for risk.
There is no grouping of assets or other techniques
that can fully eliminate risk in your portfolio, primarily
due to the lack of a full hedge for human assets.
Products with negative correlation are costly.
Further, human assets such as unemployment and
health insurance are available, but do not control all
risks.
Further, we cannot hedge away overall market risk.
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- Risk Management Theory, cont.
Risk management techniques are methods of
modifying a household's portfolio risk.
An overall portfolio risk is established, and current
portfolio risk is compared preference for risk.
The most efficient risk management technique is
then selected to bring the portfolio in line with
tolerance for risk.
In revising the portfolio one establishes a risk/return
strategy that attempts to optimize portfolio income
and brings about the highest standard of living
possible.
This approach is a part of the foundation of Total
Portfolio Management.
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- Risk Management in Practical Terms
In practice, we are only concerned with outcomes
that are below expectations as these are the
outcomes that produce losses.
Risk management in practical terms is defined as the
process by which we identify risks and control them
so that we are able to achieve individual goals.
When engaged in financial planning, you must first
identify risks knowing that losses in any one area
can jeopardize overall household goals.
Then, the ways of dealing with the risks should be
considered and the most efficient method selected.
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- The Risk Management Process
The six stages of he risk management process are
as follows:
1. Develop objectives: Select one area or examine all
household risks?
2. Establish exposures: Each area of household assets
has its own risks.
– Financial assets.
– Nonfinancial assets, both human related and real.
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- The Risk Management Process, cont.
3. Identify available risk management tools: Eight risk
management approaches are:
– Avoid risk: Seek to eliminate exposure to risk.
– Reduce risk: Seek to lessen risk.
– Reduce potential loss: Lessen damage if a loss occurs.
– Retain risk: Rejects the possibility of reducing or eliminating
risk, but instead decide to absorb the potential loss yourself.
– Diversify: Assets are diversified so that the impact of an
unfavorable outcome for any one asset is reduced.
– Transfer risk: Transfer risk to someone else.
– Sharing risk: When you transfer some risk and retain a part
of it called that sharing risk.
– Other methods of handling risk: These include options,
futures, and swaps. Hedging transfers business risk to a
7 third party.
- The Risk Management Process, cont.
4. Match appropriate risk management tools to
exposure: Different exposures call for separate risk
management tools. Factors to consider:
– The cost of alternative risk management techniques.
– The amount and likelihood of loss.
– Convenience factors.
– Risk tolerance.
Let’s look at the exposures by category and describe
the risk management tools that apply.
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- The Risk Management Process, cont.
Human-related assets: Risks include:
– Longevity – Premature Death
Longevity risk is the possibility of living beyond normal
expectations or dying prematurely.
– Longevity – Extended Life
An extra long life can result in a decline in your standard of
living or running out of private funds.
Year All deaths Death rate Life expectancy
2002 2,447,864 846.8 77.4
2001 2,416,425 854.5 77.2
2000 2,403,351 872.0 77.0
1990 2,148,463 938.7 75.4
1980 1,989,841 1,039.1 73.7
1970 1,921,031 1,222.6 70.8
1960 1,711,982 1,339.2 69.7
1950 1,452,454 1,446.0 68.2
1940 1,417,269 1,785.0 62.9
Source: National Vital Statistics Reports.
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- The Risk Management Process, cont.
– Health and disability: expenses for sickness and inability to
perform at your job.
– Macro and microeconomic risks:
Macroeconomic risk: The risk inherent in the general economy.
Microeconomic risk: The risk associated with the individual
industry or company.
Precautionary savings for such an event, government-supplied
unemployment insurance, and diversification through an
increase in the number of household members who work can
all reduce economic risks related to your job.
– In addition to your job income, there are human assets that
are derived from your rights and relationships.
Risks can be reduced through diversification of savings.
Inflation risk from flat business pension payment can be
reduced through inflation-indexed bonds.
Maintaining close relationships enhances the potential for gifts
10 and bequests at the death of a loved one.
- The Risk Management Process, cont.
Real assets: Tangible assets that the household
owns.
– Safety measures to prevent or reduce perils help.
– Many houses carry homeowners’ insurance.
– Other valuable assets such as jewelry may be insured
separately or are self-insured.
Financial assets: The ownership of assets that are
typified by pieces of paper and are often marketable.
– Risk can be covered by diversification strategies.
Liabilities: Monies owed to others.
– Reducing debt, placing caps on rates borrowed when they
are available, and accumulating precautionary savings can
serve to reduce this risk.
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- The Risk Management Process, cont.
Intangible liabilities: Less quantifiable current
liabilities such as potential liabilities to third parties.
– Care of personal property and safety precautions can be
employed.
– Umbrella insurance can cover myriad types of lawsuits.
– Professional liability insurance can help protect you in our
increasingly litigious society.
– Education about individual exposures to third-party risk and
what to do to avoid them can reduce your risk.
– Maintenance expenses can also be thought of as
obligations and intangible liabilities.
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- The Risk Management Process, cont.
5. Implement: Implementation is taking the action step.
– Setting an implementation plan with specific dates to
accomplish tasks can help avoid procrastination.
6. Review: Risk management exposures can change.
– It is a good idea to review exposures at least once a year.
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- Insurance
Insurance is a method of transferring risk. Risk is
shifted from the person exposed to it to the
insurance company that assumes the risk for a fee.
The insurance company assumes the risk after
selecting whom to insure, which is called insurance
underwriting.
By using scientific methods, the company can
estimate its exposure to loss and charge enough to
make a profit.
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- Insurance, cont.
If insurance products were fully efficient, the amount
you paid for insurance would be exactly equal to the
expected value of the loss.
Under that assumption every risk-avoiding person
would select insurance as the insurance would
provide a hedge against risk at no extra cost.
But insurance products are not fully efficient in a
financial sense due to:
15
- Insurance, cont.
Overhead Costs.
Incomplete Information.
– Moral hazard is the increased chance of loss due to policy
holder extra risk arising from such things as undisclosed
illness or faking injury after the policy is taken out.
– Adverse selection refers to people who have greater
chance of loss, purchasing more insurance than they would
normally do because of knowledge of their health that the
insurance company does not possess.
Search costs: Costs that the person desiring to be
insured undertakes to find out which policy is best.
Behavioral factors: Evidence suggests that humans
may not always act efficiently in risk management
activities.
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- Types of Insurance Policies
Personal:
– Life: Provides monies to others at the death of the insured.
– Disability: Makes payments to replace income of the
insured once the person is incapacitated.
– Long Term Care: Payment provided generally to the elderly,
which assists those unable to care for themselves due to
physical or mental conditions.
– Health: Reimburses health-related expenditures.
Property:
– Property and Casualty: Pays for losses to home and
possessions, and coverage for exposures to third-party
losses.
– Personal Liability: Extends coverage for liabilities of many
types of a personal nature.
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- Types of Insurance Policies, cont.
Government:
– Unemployment: Supplies income for a specified period
upon job termination.
– Social Security: Provides income, disability, and medical
reimbursement after retirement. And in the event of
premature death will provide payments to spouses,
children, and parents being supported.
Other:
– Welfare, food stamps, and medical preretirement: Allows
support for lower income Americans.
– Long-term care and nursing home assistance: Issued
principally for support for disabled Americans, generally
with few assets.
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- Insurance Providers
There are three major types of providers of
insurance to individuals:
– The government. The government tends to concentrate in
items with widespread exposures by cross-sections or
individual strata of society.
– Private group policies: Associated with low marketing costs,
mass volume efficiency, and reduced screening and
administrative costs. There may be tax advantages and
company subsidization as well.
– Private individual policies: Flexible and portable.
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- Analyzing an Insurance Company
Criteria include:
– Financial strength: Best, Standard and Poors, Moody's and
other agencies evaluate and rate an insurer's finances.
– Good operating sense: 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.
– Service: How good is the company’s service and does it
pay out promptly and fairly on claims submitted?
– Price: Price should be compared with quality to obtain the
best value. Pay particular attention to financial strength.
– Other considerations: These include company size, duration
in business, specialization, location, and others.
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