Risk
Life brings events affecting your financial future. You do not control many of those events. Yet you are not passively subject to events. You are instead a participant in them. You can influence events, even if not control them. You can also prepare for unpredictable events in ways that mitigate their impact on your finances. You may not be able to control many things that will happen to you or your family, affecting your finances. You can nonetheless control the financial risks associated with those uncontrollable events. Financial historian and economist Peter Bernstein in Against the Gods: The Remarkable Story of Risk credits our mastery of risk as establishing modern finance. It’s that fundamental. Your failure to address risk is irresponsible. To ignore risk is to relinquish your destiny to circumstances, diminishing your character.
Individuals
You may think of risk management as something that companies, not individuals, do. Think again. Individuals face financial risks just as companies do. To reduce the risk of tort liability, we drive with care, limit our vehicle’s use to safe drivers, and buy vehicle insurance. To reduce the risk of property loss, we install smoke alarms, lock doors, and buy homeowner’s insurance. You can likewise reduce risk and mitigate loss in your financial plan to support your spouse, educate your children, and retire with reasonable income. You can act now to achieve long-term financial goals even in the face of catastrophic loss like severe accident or illness resulting in long-term or permanent disability.
⤠ Give to those who need it and ask for it.⤟
Management
Managing risk begins with recognizing it. While some risks, like motor-vehicle accidents, are obvious, other risks, like lost services of a homemaker, are not apparent. Financial statements are risk-recognition tools. They help you see financial threats like declining earnings, excess expense, and skewed debt ratios. The AMA Handbook of Financial Risk Management defines risk management as predicting and controlling risk to create economic value. Managing risk means avoiding, reducing, or transferring it. You can avoid the risk of falling off your roof by not climbing onto it. You can avoid the risk of thieves stealing your diamonds by not owning diamonds. When you cannot avoid or reduce risk to safe margins, then transfer the risk through contract. Hire someone else to climb onto your roof to clean out the gutters. If you insist on doing it yourself, then carry health, disability, and life insurance. Insurance transfers risk to the company that issues it. If the potential loss is small, then you may choose to simply accept the risk, in effect financing the risk yourself if you should realize it. Maybe you own only a small diamond.
Insurance
Insurance is a prime way to manage financial risks. Insurance fills the gap between the goals you want to accomplish and the risks that could prevent you from achieving them. People tend to think of insurance in negative terms as insuring against negative things like accident, injury, loss, disability, and death. They then gamble by forgoing insurance, hoping in their invincibility or simply wishing to ignore bad thoughts. In positive terms, though, you insure goals more so than risks. The first step with insurance is to identify the good things you wish to achieve, and then insure against the bad things that could stop you. Insurance transfers the risk to the insurer, guaranteeing your plans with respect to the insured risk. When you choose not to insure insurable risks, you retain the risk of loss. Insurance shifts and manages risk. While some companies and advisors offer insurance as an investment, mixing risk management with investment generally makes for poorer results in both. Price and buy insurance, not an insurance investment. Invest separately.
⤠ Don’t live for fancy clothes and food. Live for better things.⤟
Evaluation
Insurance companies evaluate risk in three ways. First is the probability of suffering some measurable and compensable form of harm, injury, or loss. Second is the peril that creates the risk. And third are hazards that increase the risk. We encounter some obvious, perilous, quantifiable, and compensable risks frequently. Personal injury and vehicle damage in a motor-vehicle accident is the prime example. Other risks are less obvious, less common, and more difficult to quantify, like reputational harm from a defamatory social-media post. Some perils, like motor-vehicle accidents, are hard to avoid entirely. Few of us can stay out of and away from cars. Yet we often control at least some of the hazards. We can drive more cautiously and soberly, and ride only with more-cautious drivers. When we cannot avoid the peril and can only partially manage the hazard, then we know we face risk.
Types
Based on the above evaluation, the three main personal risks worth evaluating are (1) loss of life, (2) disability, meaning loss of the ability to work and generate income, and (3) property damage or loss. For actuaries, property damage, work disability, and loss of life are all measurable perils with clear hazards, and thus readily insurable. For you, property damage, work disability, and loss of life are equally substantial, probable, and insurable risks. Seriously consider maintaining these three kinds of insurance, depending on your personal circumstances and station in life.
⤠ Don’t worry if things haven’t worked out yet. Keep going.⤟
Rules
Follow three rules when managing risk. First, risk only what you can afford to lose. Do not insure for collision coverage your beat up old $500 car. Insure it only for liability and as law otherwise requires. The flip side of this first rule is not to risk more than you can afford to lose. Always insure your home, any vehicle for which you have not yet paid, and any vehicle that you need but cannot afford to replace. Likewise, insure your life if someone else such as a spouse or child depends on you. And insure your ability to generate income if you or others depend on it. Second, insure only what is probable, not what is certain, impossible, or so rare or catastrophic as to be meaningless. Thus, insure your life when you should live, not when you have exceeded your life expectancy. And insure against fire and storm loss, not meteor strike. Third, risk a little for a lot, not a lot for little. Collision coverage on a beat up old car still costs a lot. Risk it. Insuring a home usually costs less than one percent of its value. Do not risk it. Life insurance when you are young and healthy costs very little compared to a lifetime or earnings. Buy life insurance rather than let loved ones risk enormous earning loss. Cover catastrophic exposures like life, home, and vehicle, foremost and first.
Concentration
Considering the components of insurable risk can help you evaluate and manage your own risk. Insurance companies must be able to spread the risk, while avoiding risk concentration. The smaller the insurance pool, the greater the risk concentration. A company that insures only homes on a single Eastern Seaboard barrier island faces a significant risk concentration against a hurricane peril. A company that insures up and down the same coast and also inland areas spreads the risk. You, too, should spread risks where you can and insure where you cannot. Three decent business suits may be better than a single expensive one. More clients or customers with smaller matters may be better than fewer clients or customers with larger matters. Clients in several industries may be better than clients concentrated in one industry. More small investments may be better than few large investments. Several investments managed by different companies may be better than all investments managed by one company.
⤠ Be consistent not just with money but all things.⤟
Limits
To insure against risk, the insurer must be able to define and measure the loss. When losses are uncertain in time, place, and amount, insurers cannot predict the risk values so as to price insurance coverage. You, too, should identify and at least roughly quantify risks when insuring or self-insuring them. One way that insurers help to quantify risk is to limit the coverage. When you insure your home, the contents coverage typically has a dollar limit of perhaps one half of the home’s insured value. In the event of a total loss of the home and its content, the insurer need only pay for contents loss up to the insurer’s coverage limit. If, in your home, you store expensive jewelry or art the value of which far exceeds the contents-coverage limit, then you, not the insurer, suffer that loss. Think about coverage limits. Don’t insure against all loss. Instead, insure against enough loss to protect against what you cannot afford to lose.
Hazard
Risk has one other important component. The losses against which you insure must be accidental rather than deliberate. Insurers do not pay when an insured’s own arson is the cause of the fire loss. Generally, insurers avoid moral hazard, meaning situations in which their act of insuring a loss would increase the incentive for others to incur deliberate loss. Moral hazard is why insurance law requires policyholders to prove an insurable interest. You may take out life insurance on a spouse or business partner, not a stranger. You must have a natural relationship to protect that exceeds the value of the insurance. Insurance policies must not promote arson, business dissolution, divorce, or murder. Your financial plan needs only to manage random risks. You need not and generally cannot insure anything within your control. Your financial plan should also insure for significantly less than the total value of your potential loss. You do not want the perverse incentive of being better off with the loss. Your biggest individual insurable risks are to lose your life, ability to earn an income, or property through theft or damage.
The combination of Erin’s 30th birthday and the unexpected death of a physician friend encouraged Pat and Erin to sit down one evening to look more carefully at the financial risks that their family faced. Their physician friend had died without any life insurance. The physician’s wife had to sell the home, take a medical receptionist’s job, and move with their children into a cheap apartment. Pat and Erin realized that their own family faced similar risks. They needed financial security against the death or disabling injury of either one of them that would protect their home, provide for their children’s future education, and enable future investment and retirement savings. They had a brief laugh that it took Erin turning 30 for them to realize their mortality, but the unexpected demise of their physician friend and the financial struggles of his surviving wife and children gave them real urgency. Pat called an insurance agent the next morning.
Term Life
Insurers offer different forms of life insurance. The differences are important. Term insurance insures an individual’s life for a specific death benefit over a specific period, often for one year. The owner of term insurance may renew the policy year to year on new terms to which the owner and insurer agree. From an actuarial standpoint, premiums should increase year to year due to the insured’s increased age and nearer mortality. A healthy 40-year-old insured might pay an annual $300 premium for a $500,000 death benefit, while a 50-year-old would pay $1,000 and a 60-year-old would pay $3,000. Yet insurers will often offer fixed premiums for relatively long periods, to make term policies more attractive to the young insured. Term insurance is usually the most-affordable and best insurance for younger individuals needing larger death benefits to replace future long-term income. The short annual term, together with the insurer’s ability to increase premiums on annual renewals, reduce and rate the insurer’s risk, enabling it to offer term insurance at lower premiums than other forms of insurance offering the same death benefit.
⤠ You might think it highly valuable, but is it really? ⤟
Whole Life
Whole life insurance, also known as permanent life insurance, adds two investment features to term insurance’s annual-premium and death-benefit features. Term insurance has no value once you stop making premium payments and the policy period expires. Term insurance insures life. By contrast, whole life insurance treats the premium payments as an investment from which the whole-life policy accumulates a cash-surrender value. Depending on the whole-life policy’s terms, the policyholder may withdraw some or all of that cash value or take out loans against it. Whole-life policies also tend to promise premiums at specific levels throughout the policy’s duration, adding a degree of certainty although at a higher initial cost. Whole-life premiums are typically significantly higher than term-life premiums for the same death benefit. A young insured might pay an annual premium of as small as $160 for a $1 million term-life death benefit while paying as much as $760 for the same benefit under a whole-life policy. A whole-life policy can make a poor investment given the death benefit’s cost, disguised effective return rate, and hidden fees and terms. The Consumer Federation of America holds that term insurance is usually the better option for middle-income families. The highest income and elderly may find more estate-planning and tax-savings advantages to whole life or a universal-life product tied to securities markets.
Sufficiency
Life insurance has specific death benefits. The higher the benefit, the higher the policy’s premium. Know how large of a benefit to purchase. Younger individuals who foresee longer careers with larger future income might purchase a benefit of ten times their annual income. Thus, an individual with $50,000 in annual income might purchase $500,000 in life insurance, while an individual with $100,000 in annual earnings would purchase $1,000,000 in life insurance. At seven-percent annual investment returns, a $1,000,000 life-insurance payout would provide dependent survivors with $70,000 in annual income, approximating the after-tax value of the decedent’s $100,000 in annual earnings. Yet the 10-times rule is just a general guide. The benefit amount is a function of your age, future earned income, and financial goals. Older individuals nearing retirement may need less life insurance. Those who have no financial dependents have no future income to protect, meaning no one to miss the income if they should die prematurely. Those who depend on passive income from accumulated wealth may also forgo life insurance. Those whose employers provide a modest $50,000 life-insurance benefit (the level at which Medicare and Social Security tax-exemptions end) may have less life-insurance to purchase.
⤠ Money is a resource for other things, not an end in itself.⤟
Households
Families dependent on the earnings of household members have other factors to consider. If one household member earns all of the income, then insure that individual’s life and disability, perhaps using the ten-times-annual-earnings rule. If other household members also earn income on which the household depends, then insure their life and disability, too. Yet non-income-earning homemakers contribute their own economic value to a household. If the homemaker dies, then the income-earning survivor may have to either stay home to care for the household and children or hire others who can. Some households therefore purchase at least modest insurance coverage on the homemaker’s life. Life-insurance amounts are not something for which we have perfect equations. Contributions other than earned income are hard to value. And sometimes, we just cannot afford all of the insurance that we need. Expect to make tradeoffs.
Credit
Loan originators will often offer insurance that will pay off the loan in the event that the borrower dies. Credit life insurance is particularly prevalent with mortgage loans. When a mortgage borrower dies, neither the borrower’s dependents living in the mortgaged home nor the entity that holds the mortgage want to see a forced sale or foreclosure. Mortgage life insurance addresses that risk. Mortgage life insurance, though, is typically more expensive than the borrower simply buying a separate term-life policy in an amount sufficient to pay off the mortgage. If the mortgage borrower already has life insurance in place, then the least-expensive alternative may be to simply increase the benefit to cover the mortgage amount, if the lender and lending rules permit it.
When Pat and Erin met with the insurance agent, their annual earnings were the first things that the agent wanted to know. Pat was earning $137,000 annually, while Erin brought in another $48,000 per year. The agent recommended two policies, one insuring Pat’s life for $1.5 million and the other insuring Erin’s life for $500,000. For each policy, the agent had insurers willing to freeze the annual premiums for several years for the young and healthy couple. The agent also wanted to know their mortgage balance. The agent recommended a third policy that declined in value to match the decreasing amount of their $200,000 mortgage, ensuring the mortgage’s payment if either Erin or Pat died. Erin and Pat declined to purchase additional life insurance to cover their children’s education because the cost of additional coverage was more than they could afford. In the event that either of them died, they planned to cover education costs out of life-insurance proceeds and income of the surviving spouse.
Purchases
Shop around when buying life insurance. Term life insurance is a relatively fungible commodity. Your primary concern beyond price should be the insurer’s financial solvency. While you may get better rates from a lower-rated insurer, select one that earns a higher rating. It makes little sense to buy insurance to protect your loved ones and give you peace of mind, from a company with an uncertain financial future. Comparing prices would likely enable a couple to purchase a total of $2 million in term coverage for under $200 per month.
⤠ Use money to draw others toward good things.⤟
Beneficiaries
You designate beneficiaries when buying life insurance. A married person typically designates the spouse as the primary beneficiary. Designate children as secondary beneficiaries in the event of your spouse’s predeceasing you. Use a will to designate guardians for children and to provide for holding insurance proceeds in trust for children, in the event your spouse passes before you do or in the event of your simultaneous demise. Update beneficiary designations for changes in your relationships, including marriage, divorce, or the birth or maturity of children.
Annuities
Insurance companies offer annuities as an alternative to lump-sum death-benefit payouts. An annuity is the insurance company’s promise to pay the owner or annuitant a fixed sum on a periodic basis, often monthly, for a fixed period of years such as 10, 20, or 30 years. The annuity’s monthly payments depend on the rate of return that the purchaser is able to negotiate. Assume for a moment that a husband were to die leaving the wife to care for their children with the benefit of $1.5 million in term life insurance. The wife could take the full death benefit in cash to manage as an investment. Alternatively, the wife might purchase an annuity that would pay a fixed sum annually for a fixed period of years. A 4% rate of return on $1.5 million would fund a 40-year annuity paying $72,870 per year. Keep in mind the effects of inflation. Annuity payouts that do not rise with inflation can be a lot smaller later than they look today. At 3% annual inflation, a $72,870 annual payment will in today’s dollars be worth only $40,296 in 20 years. Annuities have the advantage of transferring the investment risk to the insurer, although you then depend on the financial solvency of the annuity company.
⤠ Money can’t buy the most-important things.⤟
Health
Maintain health insurance. You are only one accident or illness away from substantial medical costs. The Institute of Medicine and other reliable sources report that those who have health insurance improve both their financial security and personal health. Emergency room or clinic access does not provide the benefit of health insurance’s preventive care and other minimum-coverage requirements. Uninsured patients get about half the medical care received by insured patients. The uninsured get fewer screenings for preventable conditions like high blood pressure, while their cancers advance to later stages before diagnosis. Uninsured pregnant women get less prenatal care resulting in poorer delivery outcomes, while uninsured children also receive less care. The risk is not simply financial but also to your health.
Disability
Disability insurance protects both your dependents and you if you are unable to work because of illness or injury. Statistically, a disability of three months or more is significantly more likely than an early death. Disability is also much more likely than other things for which we insure, like a home fire or serious motor-vehicle accident. The Social Security Administration reports that 25-year-old workers have a 30% chance of extended disability at some point before retirement. Social Security disability benefits provide some protection but typically at a much lower level than private disability insurance, under a narrower disability definition, and after a minimum six-month delay. Worker’s compensation insures only work-related disability. Some employers offer long-term disability insurance as a benefit, while some pensions offer disability benefits. Investigate your options. If you are your household’s primary financial support, then price and budget for enough disability insurance to protect your household.
⤠ Beware thinking you have everything just because you have money.⤟
Amount
Insure for disability not at your full income but at enough of your take-home pay to keep your household running. If your gross income is $10,000 per month, you need not insure for coverage of $10,000 per month. You might insure for $5,000 of coverage, enough of your usual take-home pay to manage your finances in the event of disability but not so much that you would do just as well not working. Use your household budget to determine a reasonable figure, both from the standpoint of the monthly benefit amount that you would need and the premium you can afford.
Property
After your life, health, and disability, property loss is the next risk to consider. Lenders will generally require that you maintain property-damage coverage on any asset that you purchase with their loan in which they have a security interest. Your home is an example. No mortgage lender will allow you to leave your home uninsured for fire and other catastrophic loss. If you lose the home, then they lose their security interest. Mortgage lenders use various administrative means to ensure that you keep up on your home-insurance premiums. Your vehicle is another example. The company financing your vehicle will require that you keep it insured for collision loss. Beyond those requirements, insure those things that you cannot readily afford to replace. When you pay off your home and vehicle, insure them as long as they have any substantial value, unless you have grown so wealthy as to be readily able to replace them without affecting your financial plans and security. Check the coverage limit, too. Home values can increase well above the insurance coverage that you purchase.
Contents
Homeowner’s insurance also generally covers contents of the home up to the contents-limit amount. People generally underestimate the value of their acquired personal property. Those shirts, pants, sweaters, and coats in your closet add up. And we tend to accumulate more things than we think. You probably own more clothing, household goods, electronics, furniture, and recreational equipment than you realized. Your homeowner’s insurance should have contents-loss coverage. Check to be sure that it does. And check the contents-loss limit. Insurers tend to offer contents coverage at a relatively low limit such as one half of the home’s insured value. Consider increasing the contents-coverage limit, especially if you are a collector. If you rent rather than own a home, then judge whether you could afford to lose all of your things to theft or fire. If not, then purchase renter’s insurance. If you do insure for contents, then be ready to prove what you own. Briefly video-record all that you own. In the event of fire, flood, or theft, your brief video may be your best proof of loss.
⤠ Prosperity doesn’t mean goodness. The rich aren’t better than the poor.⤟
Liability
Property-loss insurance like home and vehicle coverage typically provides liability coverage at the same time. Check to see. If someone slips or trips and falls in or around your home, be sure your homeowner’s insurance provides liability coverage. If your spouse or child carelessly drives your vehicle injuring others, be sure that your vehicle insurance provides liability coverage, as the law requires. Appreciate the value of this coverage. Accidents, especially motor-vehicle accidents, cause billions of dollars in loss annually. As cautious as you may be, accidents happen, often involving only a brief moment’s uncharacteristic lapse.
Limits
Ensure that you have sufficiently high liability limits. State laws require motor-vehicle owners to maintain liability insurance to protect those injured by the careless operation of the owner’s vehicle. Yet those state laws may require as little as $10,000 of liability coverage for each person whom the negligent driver injures. Ten thousand dollars, or even $20,000 or $25,000 (common minimum limits in other states), does not go very far to compensate for serious motor-vehicle accident injuries. If you purchase only your state’s minimum liability limits and a driver of your vehicle carelessly injures another, then you may owe that injured person hundreds of thousands of dollars more in damages over your low liability limits. Increasing your liability limits is often not expensive. High-income earners or those with substantial assets should have no less than $250,000, $500,000, or even $1 million or more in liability limits. You may alternatively be able to buy an umbrella policy for as little as $300 per year, further protecting your assets and income.
⤠ Money brings temptation.⤟
Uninsureds
You can also insure against someone else with no insurance or with very low insurance limits injuring you or a member of your household. Motor-vehicle insurers offer uninsured motorist (UM) coverage and underinsured motorist (UDIM) coverage. For a modest annual premium, often just a few dollars added to your own liability coverage, you can purchase insurance that will pay you or your family member a benefit when the negligent person who caused the injury does not have enough insurance. The rate of unlawfully uninsured motorists is well over 20% in some states. Uninsured and underinsured-motorist coverage protects against that significant risk.
Exclusions
Watch for insurance exclusions. Exclusions bar insurance coverage even though the coverage-triggering event falls within the underlying coverage. A business-use exclusion in homeowner’s coverage is an example. If you start a business in your home and incur a loss or liability in connection with the business, such as your home burning down or a client or customer suffering injury, you may lose your insurance coverage unless you obtained a business-use rider in advance. Your insurer may also have excluded coverage for loss from wood-burning stoves, backyard pools and trampolines, guns, and similar hazards unless disclosed on the insurance application and expressly covered by a rider. Excluded drivers on motor-vehicle insurance are another example. If you have a minor child who is just turning driving age, then that child is likely an excluded driver unless you buy the extra coverage. Whenever you begin a new activity carrying risks, consider the insurance implications. Do not presume coverage for your risky new venture. Your insurer has probably thought of the risk and excluded it. Investigate and purchase coverage.
⤠ Money never satisfies. One never feels as if one has enough. ⤟
Malpractice
If you are a professional offering consumer services, whether a lawyer, doctor, nurse, counselor, accountant, engineer, or even a cosmetologist, social worker, or tradesperson, also consider the malpractice risk. Professionals typically have malpractice insurance available to them, through their employer, professional association, or private insurer. Individuals working in the trades may likewise have insurance or bond coverages. Licensing laws, rules, and regulations may require insurance or bonds, or may require disclosure of coverages as consumer information. Know the risks of your profession or trade, and obtain appropriate liability coverage with suitably high limits. See Part II on business finances for more about malpractice risks.
Checklist
Reflect, research, investigate, and act until you are able to confirm each of the following statements summarizing the advice and counsel in this section:
I am responsibly managing and reducing my financial risks.
I maintain term life insurance with a benefit sufficient to protect those who depend on my earnings.
I have health insurance in place for myself and each member of my family who depends on me financially.
I have carefully evaluated the benefit and cost of disability insurance and made a responsible decision regarding coverage.
I have insured my home for fire and other loss and damage, including adequate contents coverage and a responsible liability limit.
I have insured my motor vehicle for collision loss, a responsible liability limit protecting my financial security, and uninsured and underinsured-motorist coverage.
I know my malpractice risk and am covered with a suitable insurance policy or bond.