4 Ways to Manage Risk

Every risk we face can be addressed in one of four ways. Each may be an appropriate choice, depending on the circumstances and type of risk in question:

  1. Avoidance
  2. Reduction
  3. Transfer
  4. Retention

1. Avoiding Risk

The surest way to prevent the potential loss arising from a certain activity is to completely avoid it. For example, if I want to avoid the possibility of having to pay for a stranger’s medical expenses due to an auto accident, I could stop driving a car. So why not just avoid all risks?

The problem is that whenever we avoid a risk we also miss out on the benefits we could have received for participating in the associated activity. In addition, not all risks can be completely avoided, such as the risks of illness or natural disaster.

Avoidance may be appropriate for a limited number of risks that produce a high probability of loss, such as gambling, but it is not a practical solution for most risks. In some cases we may even create additional risks by trying to avoid a particular risk. For example, we may be tempted to keep all of our savings in cash to avoid the risk of investment losses, but then we would be subjecting ourselves to the potential risk of loss by inflation, which is practically guaranteed to significantly erode the value of our cash over time.

 

2. Reducing Risk

If we are unable or unwilling to avoid an activity, we can take steps to reduce the probability and potential severity of loss associated with the activity. For example, when we choose to drive, we can reduce the risk of being involved in an automobile accident by observing the speed limit and other traffic laws, not texting while driving, and not driving while drowsy or drunk. We can also reduce the severity of injury to ourselves in the case of an accident by always wearing our seat belts and by driving vehicles with airbags.

 

3. Transferring Risk

Another way to deal with risks we are unable or unwilling to completely avoid is to transfer them to a third party. We can transfer risk in several ways, but the most practical, cost-effective, and common approach for high-severity risks with a low probability of occurrence is through insurance. The most effective use of insurance is to cover only the unlikely potential losses which would financially devastate us if they occurred. In these areas, we should seek to maximize our protection and minimize the cost.

Life insurance is one example of appropriate risk transfer. If a young breadwinner with a non-working spouse and small children were to pass away prematurely, his or her family would find themselves in a very desperate financial situation. A young family is not likely to have enough assets to care for its own long-term needs without the breadwinner’s earned income, so transferring the risk of his or her premature death to an insurance company is usually the best solution.

 

4. Retaining Risk

If we do not make a conscious decision to avoid or transfer a risk, then by default we retain it, accepting full responsibility for the potential loss. In some cases, retaining a risk is no big deal. In other cases, retaining a risk could completely devastate us. Retention is the most suitable approach when the potential severity of a loss is low, regardless of how frequently it is expected to occur, or if the cost of insuring the risk would be higher over time than the actual potential loss incurred.

A great example of this is total replacement coverage for a smart phone. When recently upgrading my wife’s smart phone, I chuckled at what our service provider was offering. The monthly payment for their total replacement insurance plan would be enough for me to buy her a brand new phone in less than two years. Under the terms of this plan, to receive a replacement phone she would also have to pay a deductible of about half the original cost of the phone. We decided that if something did happen to her phone, it would not hurt too much to simply buy a new one, so we chose to retain the risk ourselves by not purchasing the replacement plan.

Risk retention typically is not the best strategy if the potential severity of a loss is high, even if the probability of loss is low, such as the risk of incurring hundreds of thousands of dollars worth of medical bills due to life-threatening injury or illness. When we retain a risk, we must be prepared to finance the loss ourselves.

Trying to retain high severity risks often results in less efficient use of significant resources, such as too much money in a liquid savings account that could be earning more in other investments. Another cost associated with retaining risk may include lost productivity due to unnecessary stress and worry. When we choose to retain risk but do not know for sure whether we could absorb the potential loss, we may become debilitated by fear.

Risk retention in moderation can be a prudent approach when properly combined with risk transfer, in the form of high deductibles on insurance coverage. Low deductibles can actually be very expensive because they typically require much higher premiums without providing much benefit. High deductibles can significantly reduce insurance premiums while still making the impact of large losses affordable.

Prudent Risk Management

How can we know which of the four risk management approaches is the best for any given risk? Prudent principles dictate the following:

  1. If the expected frequency and loss severity of a risk are high, we should avoid the risk, because retaining or insuring the risk would be far too expensive.
  2. If the expected frequency is low but the potential loss severity is high, we should transfer the risk to a third party, such as an insurance company.
  3. If the expected loss severity of a risk is low, regardless of how frequently it may occur, we should retain the risk.
  4. When retaining or transferring a risk, we should also reduce the potential frequency and severity of losses as much as possible.

Once we are aware of the biggest threats to our financial security and have decided which of the four risk management techniques we will employ to address each risk, we can be at peace knowing that we did the best we could. We will have a plan in place so we no longer have to worry about how we would cope if disaster struck.

Often it makes sense to utilize a combination of techniques to manage a particular risk. For example, to return to our driving example, we could refuse to drive at night if we have poor eyesight (avoiding risk), always wear seat belts and obey traffic laws (reducing risk), maintain high liability limits on auto insurance (transferring risk), and choose high deductibles to decrease insurance premiums (retaining risk).

On the next page we’ll take a closer look at the most effective ways to transfer risk to insurance companies.

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