In theory, there are five methods of risk management: avoidance, retention, reduction, transference, and sharing.
Life Insurance: Structure,
Concepts, and Planning Strategies*
4
*This chapter was critically reviewed and updated by Anton T. Vanek, Jr., ChFC, CLU, associated with AXA Advisors, LLC, 525 E. Big Beaver Road, Troy, Mich. 48083. Tel: 248-519-5535. He can be reached at anton.vanek@axa-advisors.com. However, only the authors are fully responsible for the contents presented in this chapter.
Risk Avoidance
Certain types of risk can be totally avoided. For example, a physician may choose not to practice as an obstetrician, avoiding the lawsuit risk. An individual afraid of getting injured may choose to avoid high-risk recreational activities such as mountain climbing or skiing. The investor may avoid the risk of losing principal by not investing in stocks. However, it may not be practical to avoid all these types.
Risk Retention
Another potential problem is risk retention. Here, the person assumes the risk (sometimes referred to as “self- insurance”). Risk can be retained on a voluntary or an involuntary basis. Generally, people who assume risk voluntarily do so because they have sufficient resources to handle the loss. For instance, individ- uals may decide against purchasing life insurance because they are inde- pendently wealthy. So the families would be able to maintain the current lifestyle in the event of their untimely death. By contrast, involuntary risk assumption occurs when the risk-taker fails to transfer the risk to an insurer. An example of involuntary risk assumption is a homeowner unable to obtain earth- quake or flood insurance. It is important to point out that retention can only be a viable alternative when the exposure is not catastrophic, either financially or nonfinancially.
Risk Reduction
Another means of managing risk is to reduce the likelihood of the occurrence.
How? Use loss prevention and control. Examples include: installation of home smoke detectors and burglar alarms, installation of a car theft alarm, and a commitment to eating healthy and exercising regularly. Congress enacted the Occupational Safety and Health Administration (OSHA) to encourage “safe and healthful working conditions” in work environments. Insurance companies control risk exposure by using the law of large numbers. By insuring the lives of millions of people, insurance companies dramatically reduce their risk expo- sure. That is because they know that statistically only a small percentage of insured individuals will die during any given time period.
Risk Transfer
Often the preferred method of managing rise is to transfer it to a third party. In this chapter and the next, we will consider various insurance policies that enable personal and business risk transfer. Other examples of risk transfer include:
hedging (which refers to the simultaneous buying and selling of a contract), a
surety arrangement (the individual is bonded against loss), and a “hold harmless”
agreement (one person assumes the potential loss of another person).
Risk Sharing
Another method of handling risk is to assume a limited or manageable degree of risk and transfer the balance of exposure to one or more organizations. For example, an insurance company shares risk with its clients by integrating deduct- ibles and coinsurance provisions into the policy. Individuals might use contrac- tors (who maintain business insurance) to perform construction activities in their homes. A sole proprietor of a business might become a corporation. This provides the corporate shield of limited liability. Insurance companies often mitigate market risk exposure by purchasing insurance through a reinsurance company.
Here, risk takers assume only a manageable degree of risk.
A summary of this discussion is presented in Figure 4.1. As the figure reveals, risk sharing, and risk transfer are strategies that lead to the selection of an
Potential liability losses
Potential personal losses Risk Potential property losses identification
Risk avoidance
Risk
reduction Risk
retention Risk
sharing Risk
transfer
Selecting of insurance companies Decision
Risk evaluation
Figure 4.1 Personal Risk Management: An Overview Source: Author’s own work.
Table 4.1 Risks and Risk Management Strategies
Risks Strategies for Reducing Financial Impact Personal
Events Financial
Impact Personal
Resources Private
Sector Public
Sector Disability Loss of one
income Loss of services Increased
expenses Other losses
Savings, investments Family observing
safety precautions Other resources
Disability insurance Other strategies Worker’s
compensation
Disability insurance Social Security Second Injury
Funds Illness Loss of one
income Catastrophic
hospital expenses Other losses
Health-enhancing behavior Saving and
Investing Nursing home
care
Health insurance Health maintenance
organizations Other strategies:
State Insurance Exchange
Military health Medicare,
Medicaid
Death Loss of one income Loss of services Final expenses Other expenses
Estate planning Risk reduction Other resources
Life insurance Other strategies Long-term care
insurance
Veteran’s life insurance Social Security
survivor’s benefits Retirement Decreased income
Other expenses Savings Investments Hobbies, skills Other resources
Retirement and/or pensions Other strategies
Social Security Pension plan for
government employees Property
loss Catastrophic storm damage to property Repair or
replacement cost of theft
Property repair and upkeep Security plans Other resources
Automobile insurance Homeowners
insurance Flood insurance
(joint program with government)
Flood insurance (joint
program with business) Federal Disaster
Relief Liability Claims and
settlement costs Lawsuits and legal
expenses Loss of personal
assets and income Other expenses
Observing safety precautions Maintaining
property Other resources
Homeowners insurance Automobile
insurance Malpractice insurance Other strategies
Source: Adapted from Personal and Family Financial Planning: A Staff Development Workshop for Secondary School Trainers and Teachers (Washington, D.C.: American Council of Life Insurance, 1983, p. vi/13d.
appropriate insurance company. Examples of risks and risk management strate- gies across a variety of personal events are presented in Table 4.1. Transferring risk to an insurance company is one of the many ways of handling risk. Other means of avoiding or reducing risk include: personal savings, security plans, and health-enhancing behavior.