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

(continued) Insurable Risk • 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

(continued) Spreading the Risk • 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

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 Insurance Terminology 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

(continued) Reducing Insurance Costs • 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

(continued) Reducing Insurance Costs • 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