moneyFYI
Financial Freedom Is Merely Organized Common Sense
Managing Risk
Risk is always in the future. The possible outcomes range from high cost to low cost and the probability of occurrence ranges from high to low as well.
Risk can be analyzed on six scales:
- Is it a single factor risk?
- How exposed are you?
- Can you measure the loss?
- Do you have the financial capacity to absorb the loss?
- Do you have adaption skills to deal with the loss?
- How do you feel about losses.?
Single factor risks are the easiest. Things like dying young, or being involved in a car accident, or having your house burn. The cost can be known and given the state of actuarial science, the probability can be assessed too. Most single factor risks are insurable.
Multi-factor risks are harder and often are not insurable. If you allow your health to deteriorate by smoking, drug use, excessive drinking, or being dramatically overweight, the outcomes are not certain. Some people have genetic disposition to certain adverse health issues. On the other hand, some smokers seem unaffected, some overweight people live normal lives.
Most people with poor risk choices experience gradual deterioration and adaptation. The costs of a disability, or a death are large but difficult to assess. How much must your health deteriorate before you care. Would working at 70% of optimum matter? Maybe 40% would. That is an important factor in choosing disability insurance assuming you could get it at all.
When it starts to matter is an even harder question. You should go with the probabilities. Multi-factor risks like these can be avoided to some extent and should be. There is no easy solution other than continuous management.
Consider diversification. Should a real estate agent invest heavily in real estate. Maybe with no leverage. Otherwise when real estate falters both investments and income go south.
Assigning cost
There are more costs than financial involved in any risk of loss situation. It is easy enough to estimate the financial loss of a premature death, but other factors like the effect on the surviving family or business partners can be known only in general. Some of those can be addressed beforehand and should be. Having a will, powers of attorney, and a shareholder agreement would be a good start. Each would require you to think through the problem in some detail.
The financial cost will just be a number and you can decide the cost / benefit of dealing with it. For those with large financial capacity and small potential losses, keeping the risk may be an option. For others insurance is usually the choice.
Adaptation
Adaptation is about you and how you view the world. Sometimes adversity brings out the best in people other times not. We all know of people who were seriously injured in a car accident who went on to overcome their disability and make contributions. There are others who failed to adapt.
Insurance aids adaptation. While money does not guarantee success in any adaptation, it improves the odds. People talk about being insurance poor but they are usually looking at the premiums, not the potential cost of a loss. The reality of life is the ones who are truly insurance poor are the ones who had an insurable risk they did not cover well enough. Perhaps surviving family. Perhaps a disabled individual. Perhaps someone who was sued beyond the limits of their auto polciy. Maybe the ones who underinsured their house to save premium and discovered what happens when their is a partial loss.
Insurance is only expensive when you don’t need it. I have never heard of anyone who had a claim complaining there was too much insurance and I doubt I ever will. Worry about having had too little is not so rare though.
Manage your insurance portfolio so the costs for premium is for the right kind of cvoerage given your need for coverage. Be aware of options. Some are valuable and others are not. Seek advice from people who know how to do it.
Loss Aversion
Loss aversion and risk tolerance are closely related. Most of us have less risk tolerance than we expect when the risk turns into a loss. When the stock market crashed in 2008 and 2009, many sophisticated investors found they could tolerate risk but not loss.
We should find early on how we relate to loss. If loss leads to fear, our decision making skills will deteriorate and weak decisions will be added on top of an already adverse sitation.
Many people will benefit from an external counsellor who can help keep their fear in check, help them examine options, and provide a broader perspective on the situation.
Risk tools
Portfolio design will have an effect on how exposed you are to paper losses. Diversification will help, but it is primarily a defense to your emotional reponse to loss. I suppose there will be little exposure to huge gains, too. There will be few of them in a balanced protfolio and so the greed response is attenuated too.
Depending on how you understand your loss aversion issues, you can decide how to proceed here. Review the point of using assets that are not correlated positively. You want to reduce the variation of value exposure of the entire portfolio and it will mean making allocation decisions that relate to factors other than maximum yield.
Insurance is the simple solution to many risk situations. While insurance is simple enough to contemplate, it is far from simple to execute. There are innumerable policies that cover a given risk in slightly different ways. There are hundreds of companies competing in the marketplace. Each has its own way to deal with the risk they are accepting.
There are optional coverages and things like deductibles that affect premiums. You must walk through the variations to decide which best matches your situation. You will require help and you will not find it online.
Cheap is expensive
With any insurance policy dealing with a risk of known dimensions, you will find price is a poor indicator of value. You will eventually care more about value than price but maybe not in the beginning. When you decide to get best value instead of lowest price, you will address an obvious point.
All insurance costs the insurance company the same amount. If they sell it for a lower premium somewhere in the policy, something will be missing. If you don’t know what is missing, you are accepting some of the risk you hoped to transfer to the insurer.
For example,
- Insurance that could be cancelled by the insurer is less valuable than insurance that cannot be cancelled. Would you be able to replace it?
- Insurance that is not transferrable. Like employer group or creditor or association insurance. What do you have when you leave?
- Some insurance does not have guaranteed future permiums.
- Some insurance allows the insurer to revisit the facts at the time it was issued and if there are “pre-existing conditions” they can return your premiums instead of paying. Underwrite the risk at the time of claim is a serious defect in a policy.
- Some companies, often disability carriers, aggressively deny claims. Others do not. Ask about claims history and payments ratio. Large responsible companies will be paying over 90% of claims submitted in a timely fashion. They can explain what happened to the others. The most common reasons for denial of a claim by a responsible carrier are:
- The policy was not in force at the time of the event.
- The wait time for coverage to begin had not be met.
- The claim is for conditions not covered in the policy.
Think about this. You are a 40-year-old male non-smoker in good or better health. You have no unusual risk factors in your job or activities. You are financially responsible and own appropriate coverage for your situation. Do you think the probability of your dying in the next five years will be different because you bought a cheaper policy from company B?
Certainly not. The risk of a claim and its cost if paid is identical for every insurer. Their costs to create the policy and process it after issue are near identical. The investments available to them for the premiums are identical. Their tax rates are the same.
So, if all the cost factors for each company are the same how can a company responsibly sell it for less? Only if they did not sell as much and you don’t know what is missing.
Many years ago during a review I discovered a client had a $1,000,000 “personal catastrophe” policy. The premium was $270 annually. Upon examination, we decided the policy would pay if the client was killed by a rabid female yak, while climbing the north face of a Himalayan mountain. In April. In all other cases of death, he could stop paying premiums.
Moral of the story
In any kind of insurance, cheap is likely to be expensive if there is a claim. Do you want to insure two things? The risk you know you have and the possibility the insurer might not pay.
A thought from John Ruskin.
“It’s unwise to pay too much, but it’s also unwise to pay too little. When you pay too much, you lose a little money ….. that is all. When you pay too little, you sometimes lose everything because the thing you bought was incapable of doing the thing it was bought to do. The Common Law of business balance prohibits paying a little and getting a lot … it can’t be done. If you deal with the lowest bidder, it is well to add something for the risk you run, and if you do that, you will have enough to pay for something better.”
Know what you are trying to do and get the best coverage match you can afford.
I help people understand and manage risk and other financial issues. To help them achieve and exceed their goals, I use tax efficiencies and design advantages. The result: more security, more efficient income, larger and more liquid estates.
Please be in touch if I can help you. don@moneyfyi.com 705-927-4770
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