Chapter 10

PDP

Financial Planning Handbook

67

How can we manage risk?

hile risks cannot be eliminated, measures can be taken to reduce the probability and size of loss caused by risks. This process is known as risk management.

Response to risk
The different methods used for management of risk can be broadly categorized into two categories: Risk Control Risk Financing Risk Control Risk Control methods are those that try to minimize the losses from risks. These can be of two types: 1. Risk Avoidance Risk avoidance is accomplished by not engaging in the action that gives rise to risk. Avoiding risk is an appropriate strategy for high frequency and high severity risks. While the avoidance of risk is one method of dealing with risk, it has many negative consequences. for example, you can avoid dying in an air crash by giving up air travel, but it also means giving up the huge time savings and convenience that air travel offers. 2. Risk Reduction Risk reduction is achieved through loss prevention and control. For example, the risk of fire can be reduced by measures like installing fire extinguishing systems and sprinklers, using fire retardant materials in construction. It is an appropriate strategy for high frequency and low severity risks.

Risk Financing
Risk financing methods are those that pay for losses that actually happen. These can be of two types: 1. Risk Retention Risk retention is used when the risk is retained. The retention may be voluntary or involuntary. This is an appropriate strategy for low frequency and low severity risks. For example, the risk of suffering from common cold can be retained. As a general rule, risks that should be retained are those that lead to relatively small certain losses. The reason for retention is because there is a cost attached to transfering, reducing or avoiding risk. It may be more cost effective to retain the risk since its frequency as well as impact is low. 2. Risk Transfer Risk transfer is the transfer of risk from one individual to another who is more willing to bear the risk. Insurance is the most widely used means for reducing risk by transfer. Risk transfer is appropriate for low frequency and high severity risks.

68

Financial Planning Handbook

PDP

Risk Management

Let us try to understand these for concepts better through some examples. Examples 1] Vikram had a run of 7kms from home to his office. There are two routes he can take. One route is faster, but highly dangerous. It is a main highway and has a record number of accidents. In other words, the area is accident-prone. The second route typically takes him 15-20 mins more. Since it is an inner city road, it has less of heavy traffic and this route is considerably safer. Which kind of risk would you classify this as? What is the best way to deal with it? Since his travel frequency in that route was twice a day, back and forth from home to office, in case of any accident, the impact would be fatal, hence it can be classified as high frequency, high severity risk and best way to deal with it is Risk avoidance. 2] Anand was earning well in his company. His friendliness was unfortunately taken as his vulnerability. Whenever, any of his friends needed some money, they would invariably ask Anand. Anand could never say no, and always felt that he should help someone in need. The loan was always given on a returnable basis, but that never happened. What kind of a financial risk does it entail? How should it be handled? This can be classified as high frequency, low severity risk hence best way to handle it would be Risk reduction. C] Prem was to take an official trip to USA. His wife also wanted to join him, as a personal holiday trip. His company gave Prem an insurace cover. Should his wife also take an insurance cover? What are the risks that could arise incase the risk cover is not taken? What is the category of risk and how should it be handled?

PDP

Financial Planning Handbook

69

The chance of his wife meeting with an accident is low, however if she does, the severity would be high hence best way to deal with this is Risk transfer. D] Laxman and Preet used to go and play together everyday with the other boys of the building. All of them got together and played cricket in the nearby playground.It is quite possible that one of them gets hurt while playing. What is the probability and the risk of such an injury? How should such a risk be handled? It is a case of low frequency and low severity, hence Risk retention is the best way to deal with it.

Personal Risk Management

The methods discussed above can also be applied to the financial risks to which an individual is exposed. List of some of these events that have the potential to cause financial loss (whether through increase in expenses or through decrease in earning potential) are given below: Death Disability Major surgery or hospitalization Illness Liability for injuries to others Burglary of home Destruction of house and contents Car accident major or minor damage to car Professional Liability, etc. Steps to handle Personal Management Risk: Step 1 : List down all the risks. Step 2 : Rate each event for severity of financial loss. Severity of financial loss can be categorized into: a. b. c. d. Extremely Severe an event that is financially devastating, possibly resulting in bankruptcy. Very Severe an event that has a huge financial impact that can radically change lifestyle of the affected person. Moderately Severe an event that has an uncomfortable but manageable financial impact. Not Severe an event that has very little financial impact, that can be covered by emergency cash reserves held in liquid form.

Step 3 : Rate each event for probability or frequency of occurrence. Frequency of occurrence can be categorized into: a. b. c. d. Extremely Probable/Frequent an event that is almost certain to happen, or that happens very frequently. Very Probable/Frequent an event that is quite likely to happen, or that happens often. Moderately Probable/Frequent an event that could happen, or that happens infrequently. Not Probable/Infrequent an event that is unlikely to happen, or that almost never happens.

70

Financial Planning Handbook

PDP

Step 4 : Plot all events into the four quadrants as per the following rules: High frequency and High severity High frequency and Low severity Low frequency and High severity Low frequency and Low severity Risk Avoidance Quadrant Risk Reduction Quadrant Risk Transfer Quadrant Risk Retention Quadrant

Step 5 : Compare the recommended methods of handling risks with the ways they are currently handled, to identify gaps or mismatches in the current risk management strategies. Create an action plan to plug the identified gaps. Keep in mind that: Step 6 : The topmost priority must be given to risks that should be avoided or transferred but are being borne. These risks can completely wreck the financial affairs of a person. Accordingly, they need to be handled foremost. Next priority should be given to risks that should be reduced but are being currently borne. These risks should be immediately managed by making lifestyle changes and by putting appropriate loss control mechanisms in place. If risks that should be borne have been transferred through insurance, the amount of insurance may be reduced or completely eliminated. The resultant cost savings should be employed into addressing the other gaps. The most common method of risk transfer is insurance. In the next chapter, we will discuss the relationship between risk and insurance.

Chapter Review

PDP

Financial Planning Handbook

71