Introduction to Risk Management

25 Introduction toRisk Management 25.1 Understanding Risk 25.2 Managing Risk

Lesson 25.1Understanding Risk GOALS • Explain risk and the different types of risk. • Explain the concept of insurance and how risks are spread. • Chapter 25

Types of Risk • Pure risk • Speculative risk • Economic risk • Insurable risk • Chapter 25

Pure Risk • Pure risk is a chance of loss with no chance for gain. • Pure risks are random (can happen to anyone) and result in loss (not gain). • Examples of pure risk include the following: • Accidents resulting in physical injury and damage to property • Illnesses that people get throughout life, as a part of aging • Acts of nature, resulting in damage to persons and property • Chapter 25

Speculative Risk • A speculative risk may result in either gain or loss. • Because speculative risks are not “accidental” or random, and may result in either gain or loss, you cannot protect yourself from losses in a traditional manner. • While hedging (making an investment to help offset against loss) is a technique used to help reduce losses from such risky acts, it does not reduce the risk itself. • Chapter 25

Economic Risk • Economic risk may result in gain or loss because of changing economic conditions. • For example, when the business cycle is in a period of recovery or growth, most people and businesses are realizing gains in their financial position. • However, the economy can slow down. • During this time, people lose jobs and are unable to buy goods and services. • As a result, many businesses find themselves unable to meet their debts. • Chapter 25

Insurable Risk • You can reduce negative consequences of a pure risk by purchasing insurance. • Insurance is a method for spreading individual risk among a large group of people to make losses more affordable for all. • An insurable risk is a pure risk that is faced by a large number of people and for which the amount of the loss can be predicted. • Chapter 25

Insurable Risk • (continued) • Insurance companies can make these predictions by examining the amount of loss incurred from past events, such as flooding. • To purchase insurance, you must have an insurable interest to protect. • An insurable interest is any financial interest in life or property such that, if the life or property were lost or harmed, the insured would suffer financially. • There are three major insurable risks: personal, property, and liability. • Chapter 25

Personal Risk • A personal risk is the chance of loss involving your income and standard of living. • You can protect yourself from personal risks by buying life, health, and disability insurance. • In addition, insurance against personal risks protects others who are depending on your income to provide food, clothing, shelter, and the comforts of life. • Chapter 25

Property Risk • The chance of loss or harm to personal or real property is called property risk. • For example, your home, car, or other possessions could be damaged or destroyed by fire, theft, wind, rain, accident, and other hazards. • To protect against such risks, you can buy property insurance. • Chapter 25

Liability Risk • A liability risk is the chance of loss that may occur when your errors or actions result in injuries to others or damages to their property. • For example, you could accidentally cause injury or damage to others or their property by your conduct while driving a car. • Or a person could fall because of your home’s crumbling front steps and break an arm. • Liability insurance will protect you when others sue you for injuring them or damaging their property. • Chapter 25

Spreading the Risk • An insurance company, or insurer, is a business that agrees to pay the cost of potential future losses in exchange for regular fee payments. • When people buy insurance, they join a risk-sharing group by purchasing a written insurance contract (a policy). • Chapter 25

Spreading the Risk • (continued) • Under the policy, the insurer agrees to assume an identified risk for a fee, called the premium, usually paid at regular intervals by the owner of the policy (the policyholder). • The insurer collects insurance premiums from policyholders under the assumption that only a few policyholders will have financial losses at any given time. • Chapter 25

Indemnification • Insurance is not meant to enrich—only to compensate for actual losses incurred. • This principle is called indemnification. • Indemnification means putting the policyholder back in the same financial condition he or she was in before the loss occurred. • Chapter 25

Insurance Terminology • Actuarial table • Actuary • Beneficiary • Benefits • Cash value • Claim • Coverage • Deductible • Exclusions • Face amount • Grace period • Hazard • Insurance agent • Insured • Insurer • Loss • Peril • Probability • Proof of loss • Standard policy • Unearned premium • Chapter 25

Lesson 25.2Managing Risk GOALS • Discuss the risk-management process. • Explain how to create a risk-management plan. • Discuss ways to reduce the costs of insurance. • Chapter 25

Risk Management Is a Process • While you cannot eliminate risk, you can manage it so that a loss does not become financially devastating. • Risk management is an organized strategy for controlling financial loss from pure risks and insurable risks. • Chapter 25

Risk Assessment • Risk management begins with a systematic study of the risks that you face. • It begins with risk assessment, or understanding the types of risk you will face and their potential consequences. • Risk assessment is a three-step process: • Step 1: Identify risks of loss • Step 2: Assess seriousness of risks • Step 3: Handle risks • Chapter 25

Techniques for Handling Risks • Risk shifting • Risk avoidance • Risk reduction • Risk assumption • Chapter 25

Risk Shifting • Risk shifting, also called risk transfer, occurs when you buy insurance to cover financial losses caused by damaging events, such as fire, theft, injury, or death. • By making premium payments, you shift the risk of major financial loss to the insurance company. • Chapter 25

Risk Avoidance • Risk avoidance lowers the chance for loss by not doing the activity that could result in the loss. • Examples: • Instead of having a party at your house and risking damage, you could reserve a section of a restaurant. • Instead of participating in a dangerous sport, you could go camping. • Chapter 25

Risk Reduction • Risk reduction lowers the chance of loss by taking measures to lessen the frequency or severity of losses that may occur. • For example, you may put studded snow tires on your car, install fire alarms or sprinklers in your home, or use seat belts. • All these steps would lessen the financial risk of potential losses. • Chapter 25

Risk Assumption • Risk assumption is the process of accepting the consequences of risk. • To help cushion your financial burden, you could establish a monetary fund to cover the cost of a loss. • People who self-insure plan to absorb the costs of some risks themselves. • This strategy can reduce the cost of insurance. • Chapter 25

The Risk-Management Plan • List identified risks. • List assessment of risks’ financial impact. • List techniques to manage each risk. • Chapter 25

Reducing Insurance Costs • Increase deductibles. • A deductible is the specified amount of a loss that you must pay. • Generally, the higher the deductible, the lower the insurance premium. • Purchase group insurance. • The premiums for group plans are usually considerably lower than for an individual plan. • Chapter 25

Reducing Insurance Costs • (continued) • Consider payment options. • Monthly payments usually contain an extra charge, while semiannual payments do not. • Having premiums automatically deducted from your checking account or paying electronically may reduce your costs. • Chapter 25

Reducing Insurance Costs • (continued) • Look for discount opportunities. • Many insurance companies offer discounts for special conditions. • Comparison shop. • Get quotes from several insurers. • Be sure to give each one the same information so you can compare exact coverage and costs. • Chapter 25

Introduction to Risk Management