moneyFYI
Financial Freedom Is Merely Organized Common Sense
Dealing With Risk
The actuarial sense of risk
Risk in the actuarial sense says, how much is the loss or cost to repair something, and how likely is it to occur?
Investment risk (measured by variability) is a different animal entirely. Variability is not risk in the sense that you have lost something. It requires a transaction to crystalize the loss and if you don’t have to have the money right then, nothing changes. Liquidity is the defense.
The actuarial results are different from investment risk in an important way. Actuarial risks tend to happen or not, while variability is a continuous factor in a particular marketplace.
Actuarial risk is measured by the amount and the risk of it occurring within a given time span. If a house would cost $500,000 to replace and its probability of being destroyed in the next 12 months is one in a thousand, the actuary will value the loss at $500. You and the actuary come from a different place. Because you could afford the $500 loss does not mean you should accept it. Your house cannot be 0.1% destroyed. You are in an all or nothing world. Actuaries deal with averages.
All or nothing risk can be managed
The process is fairly straightforward and is aimed at what action you should take. It involves anticipating, always a useful way to manage the future.
The management process begins with estimating the problem:
- Identify the condition that could occur. It could be the house burns, the car is stolen, I injure someone in an accident, I am sick and can’t work, I die, I make a mistake in advising a client.
- Evaluate the amount that could be lost. This is just a number. Often a large number. For most of us the probability of occurrence is meaningless. We will be in the situation that says it happened or it did not. If it did, I am out the money with 100% certainty. If it did not, I am out nothing. People often fail when dealing with unaffordable losses that have low probabilities. You cannot have a car that is 99.85% unstolen. It was or was not. If you cannot cope with the loss, you must find a way to get rid of it.
Choose one of four methods of dealing with the loss.
- Retain. Accept it as possible and ignore the risk. Small losses don’t matter enough to justify the time and trouble. How far would you go to eliminate the risk of losing an umbrella?
- Eliminate the possibility. Not always possible, but sometimes there are alternate ways to achieve a given outcome. If the cost to insure a ship to sail into the Arabian Gulf is too high, overland shipping from Egypt might work instead.
- Reduce the likelihood of the adverse event. Storing gasoline in your garage increases the extent of a fire. Smoking harms your health. Driving while intoxicated is often adverse. Eating well and exercising helps you. No reduction plan eliminates the risk, but coupled with other actions, it may make the damage less probable and maybe less severe.
- Insure the loss. Insurance companies have a different condition than you do. They do not have an on/off type of risk. If you die, you are 100% gone and the loss of income is substantial. If an insurance company has 100,000 people just like you covered, their probability of a payout is known to several decimals. Because they can price their risk, they can offer you a premium based on the averages rather than the catastrophe condition you face. Your premium will be a modest fraction of the possible loss. If you cannot afford the big loss you discovered during the evaluation, the insure decision is easy.
The important part of risk
Investment risk is not a risk except if you stop participating. Variability works both ways and eventually dies down. The average of all the noise is zero. If there is a risk of real loss, like the company goes bankrupt or you need the money now, you need to use the actuarial like methods.
Actuarial, averaged risk methods are great for insurers, but not relevant for you. You cannot be partly alive and partly dead. You must assess your risk as if you are 100% dead and go from there. Most people deal with low probability events poorly because the see the probability and not the effect of the loss.
Everyone is, or will be, insurance poor.
If you pay the premiums and have no claim, you lose the premiums. If you don’t pay the premiums you have a small gain, but if you have a claim, your beneficiaries will be poor. Pick the form of poverty that is most affordable and make an adult decision.
I help business owners, professionals, and others understand and manage risk and other financial issues. To help them achieve their goals, I use tax efficiencies and design advantages to acquire more efficient income and larger, more liquid estates.
In previous careers, I have been a partner in a large, international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. don@moneyfyi.com 705-927-4770
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