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:
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.
Why You Don’t Want to Avoid All Financial Risk
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.
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 seatbelts and by driving vehicles with airbags. Other common examples of risk reduction include installing burglar and fire alarms, building locked fences around pools, and visiting the doctor once a year for a physical exam. When investing, we can reduce risk through proper due diligence, diversification, seeking the advice of qualified experts, and investing primarily in that which we understand or can control to some extent.
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.
Effective Example of Transferring Risk through Insurance
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. Without adequate life insurance, the burden of providing for such a family may fall upon extended family, friends, church, or community.
After carefully considering the full potential impact of such an event, most people in this situation would rather transfer the risk of premature death to an insurance company because they would never want to be such a burden on other people.
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.
Example of When Retaining Risk is Better than Transferring Risk
A great example of this is total replacement coverage for a cell phone. When recently upgrading my wife’s cell 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.
Example of When Retaining Risk is Not the Best Option
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.
Adam Dawson, CFP® is a Principal at Capstone Capital and the author of Timeless Principles of Financial Security. If you need help deciding how to manage your risk, please call us to schedule a free consultation.