For those who are new to the concept, there’s much to consider when it comes to “risk management” in your personal life. How much and which types of life insurance do I need? Should I purchase disability insurance? Is my health insurance coverage adequate? These questions can be challenging, however, if you understand the 5 Steps in the risk management process, you can prioritize and plan.
The 5 Steps in Risk Management
- Identify the risk. Examples of certain risks include your health, property damage or loss, premature death, injury resulting in disability.
- Analyze the risk. Identify and weigh the probability of each risk occurring. Some may be obvious. For example, according to Lawcore.com, 25% of all drivers are involved in a car accident every 5 years. With that high probability, you want to minimize the potential of that loss by purchasing auto insurance. Other risk management choices are more difficult, like the probability of becoming disabled in your chosen field of work.
- Evaluate the magnitude of the risk. If the magnitude is small, then you will probably want to retain that risk. Examples of this are appliance maintenance agreements or product warranties of low value items.
- Determine the solution. There are three choices:
- You can choose to retain the risk. This is usually deemed the best course of action for low probability, low magnitude items.
- Reduce or eliminate your risk by avoiding the activity. For example, you can choose not to drive a car, or not to purchase a home, etc.
- The 3rd option is to purchase insurance. If the risk cannot be avoided or reduced and has a high probability, extensive magnitude, or combination of one or the other, insurance should be purchased. For example, if you have to drive, you should purchase auto insurance. If you’re a provider for your family and have a mortgage and children, you should purchase life insurance.
- Once your course of action has been taken, monitor and review. Anytime a significant life event occurs or is expected, return to step one.
Now that risk has been determined what is the purpose of insurance in risk management?
The Concept of Indemnification
The purpose of insurance is to reduce your risk by hedging against a potential financial loss. One of the main principles of insurance is to indemnify you in the event of a loss. Indemnity in risk management terms means to return you to where you were prior to the loss, compensation. For example, if your car is damaged, your auto insurance will indemnify you by paying to get it repaired. The principle of indemnification applies to all types of insurance except life insurance, as there is no way to measure the value of a human life. This is where financial planners and insurance agents come in.
Protecting Your Family with Life Insurance
Life insurance is the way individuals protect their families from a catastrophic financial event due to the passing of a key earner. With that in mind it’s important to understand the basic types of life insurance. In a broad sense, there are two types of policies: term and permanent.
Term insurance is designed to cover someone for a specified term, typically in increments of 10, 15, or 20 years with a fixed level death benefit. Term insurance also offers the maximum death benefit for the lowest cost, if you qualify. There is no ongoing accrual of cash value in a term policy. It’s purely protection.
So, in what scenarios would term insurance be appropriate? When someone wants to insure inexpensively for a temporary need or need that will fade over time.
An example of this would be a young married couple with good income but limited savings/assets and who need a contingency plan to cover their mortgage, children’s college tuitions, etc. for potentially a few decades.
Permanent insurance is most appropriate for liabilities or planning that isn’t expected to reduce over time. Unlike term insurance, permanent policies have a savings component that increases over time with premium payments and potential asset growth within the policy. For as long as the premium is paid, the policy will be “in force,” hence the name permanent.
A common scenario for selecting a permanent policy is to fund estate planning, such as leaving a legacy, estate tax liabilities, burial expenses, etc.
Another important facet of permanent policies should be viewed through a psychological lens: the potential need for “forced savings.” If you’re a person who “says” they plan to save but don’t have the discipline to do it manually, a permanent life insurance policy forces you to save and build cash value through premium payments. This is known as a “commitment device—a way to lock yourself into following a plan of action that’s the right thing to do but challenging due to any number of reasons, including human nature.
There is far more to life insurance than described here, especially permanent policies. We recommend consulting a financial advisor for individualized advice tailored to your needs.
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