Risk Management Methods
Risk management refers to the methods you can use to deal with the uncertainty of loss (risk). You
are exposed to various types of risks each day, whether you are consciously aware of it or not.
Many risks are small in nature and do not present a serious or substantial financial impact; however,
losses such as automobile accidents, serious health conditions, or loss of life can have a financially
devastating effect. So, how can you manage (not prevent) risk? Here are five basic methods:
(Acron ym STARR)
1. Sharing Risk
Sharing risk distributes risk among a particular number of individuals. Each individual is responsible
for a portion of the risk in direct relation to what that specific individual has invested. If you and I
decide to jointly buy a boat together and pay $10,000 cash for it. We agree that I will pay $4,000 and
you will pay $6,000. Instead of paying insurance premiums, we decide to self-insure the boat. I will
be responsible for 40% of any loss that occurs and you will be will responsible for 60%.
2. Transfer Risk
Insurance is the most common way—but not the only way—to transfer risk. When you purchase
insurance of any type, you are transferring your risk to an insurance company. You purchase auto or
homeowners insurance—you are transferring the risk of loss on your car or home to an insurer.
Another risk transfer method used in some circumstances is a hold-harmless agreement. This is
an agreement or contract in which one party agrees to hold the other free from the responsibility
for any liability or damage that might arise out of the transaction involved. For example, I agree to
allow your janitorial company to provide cleaning services to our office building, but require you to
sign a hold-harmless agreement indemnifying (securing against loss) me if you negligently leave a
dangerous condition that injures a visitor. I have transferred that risk to you.
3. Avoid Risk
To keep it uncomplicated, just do not perform an activity that could carry risk. You can avoid the risk
of being in an automobile accident, for example, by never getting into an automobile. You won't
have to worry about losing value in your retirement portfolio if you stick with fixed rate investments.
You are avoiding the riskier investments
4. Reduce Risk
Since risk cannot be completely avoided, the possibility or severity of a loss can be reduced by using
risk control techniques. For example, while you may not be able to completely prevent a fire from
occurring in your home, the possibility or severity of a fire can be greatly reduced by installing a fire
suppression system. Or, you can reduce your risk of dying from a sky-diving accident by giving up
your hobby of sky-diving.
5. Retain Risk
Risk retention is choosing to be financially responsible for all or part of a risk. It's on you if a loss
occurs. A good example is the boat that you and I just bought. While we shared the risk of loss with
each other, we each retained an amount equal to what we invested when purchasing the boat.
Another common example of retaining risk is when you choose to buy insurance with a deductible.
You retain or self-insure the amount of the deductible.
Reinsurance
Reinsurance is a risk management tool used by most insurance companies to lessen their risk
exposure. Companies (insurers) purchase insurance from another insurance company (reinsurer) to
transfer some risk from the insurer to the reinsurer. The reinsurer has the company's back when
losses occur. Here is how it works...
The reinsurer and the insurer enter into a reinsurance agreement which details the conditions
upon which the reinsurer would pay the insurer's losses (either in excess of a certain amount or a
percentage). The reinsurer is paid a reinsurance premium by the insurer, and the insurer then issues
thousands of policies.
As an example, assume Large Insurance Company sells 1,000 policies with an average policy limit of
$1 million to American Re (the reinsurer). Theoretically, the insurer could lose $1 billion (1,000 x $1M).
It may make more sense for Large to transfer some of their risk to American Re to help minimize their
risk. So in basic terms, a reinsurer is an insurance company's insurance company.
Principle of Indemnity
Associate the word "restore" with indemnity as it relates to a covered loss. The principle of indemnity
states that the insurance company will restore you to the same financial position you were in before
the loss occurred—no profit, no loss. To indemnify means to secure against loss and make whole
after a loss occurs. However, you should not be compensated by the insurance company in an
amount exceeding your economic loss. There should be no gain from your pain...just restoration.
For example, if your house burns down, the insurance company will pay to rebuild your house to
the same level it was priorto yourloss. They will not build a larger, more elaborate house for you. If
you remember, we discussed earlier that insurance companies will only insure pure risks. There is no
opportunity for gain or profit with pure risks.
Insurable Interest
Insurable interest usually results from property rights, contract rights, and potential legal liability.
You cannot directly benefit from any insurance unless you would lose money or value if the
insured property suffers a loss. Insurable interest is the extent of your financial interest at the time of
loss.
For example, if your house is damaged by fire, its value will be reduced; therefore, you have an
insurable interest in your home since there would a financial loss resulting from the fire. On the other
hand, if your neighbor's house is damaged by fire, you will not suffer a financial loss. You have an
insurable interest in your own house but not in your neighbor's house.
You also have an insurable interest in our boat equal to 60% of the actual cash value, while I have a
40% insurable interest.
What about your bank or mortgage company? Do they have an insurable interest in your home? If
they hold a mortgage on your house, you bet they do. Just cancel your homeowners policy and see
what happens. The insurance company is directed to notify the bank/mortgage company, as the
mortgage holder, of the cancellation. If this becomes an issue, the bank/mortgage company will
purchase insurance to cover their insurable interest in your house and send you the bill. This
coverage may not be nearly as inexpensive as the coverage you just cancelled.
When you take out a mortgage, the bank/mortgage company will usually require you to insure the
home and name the bank/mortgage company as an additional insured on your Homeowners
policy.
Coinsurance/Insurance to Value
Coinsurance describes a splitting or spreading of risk among the insurance company and the insured.
It rewards you when you buy adequate amounts of coverage; however, it can be brutal if you do not.
The issue in this case is called the coinsurance penalty. The good news is the coinsurance penalty
in a property and casualty policy can be avoided altogether if you purchase the right amounts of
insurance.
For example, let's say that you purchased a new house—the house of your dreams. Your insurance
company determines that it has a replacement value of $750,000. Your insurance policy has an 80%
coinsurance requirement, so you must insure it for at least 80% of the $750,000 ($600,000) if you
want all partial losses to be paid without a coinsurance penalty. Of course, if you only insure for
$400,000, then you will be responsible for any loss amount exceeding that amount.
Even though most losses are partial losses, it may not be a good idea to insure less than what the
coinsurance amount. In this case, if you insured your house for $400,000 to save a few premium
dollars, what would happen if you were to have a $100,000 partial loss? Would you collect $100,000?
The answer is NO...too bad, so sad. You will be penalized by the coinsurance clause. Since you only
purchased 67% of the coverage you should have, the company will pay only 67% of your claim—
with a $100,000 loss, this would be only $67,000 minus your deductible. You will have to come up
with an extra $33,000 out-of-pocket for repairs to your dream home. That's a stiff penalty for being
a tightwad!
To make sure you understand how we arrived at these numbers, let's take a closer look at the
numbers.
(Amount of Insurance Carried ÷ Amount of Insurance Required) x Amount of Loss = Claim Payment
(400,000 ÷ 600,000 = .67) x 100,000 = $67,000, minus your deductible.
Step #1: Determine minimum amount of insurance you should buy: $750,000 x 80% = $600,000
Step #2: Amount of insurance purchased: $400,000
Step #3: Actual loss amount: $100,000
Step #4: Divide the amount purchased by the amount that should have purchased, and then
multiply that percentage by the amount of loss
Loss Valuation
This is simply a method insurance companies use to decide how much to pay you for a loss. There
are several methods companies use.
Actual Cash Value (ACV)
ACV is computed by subtracting depreciation from the replacement cost. The depreciation is
usually calculated by establishing a useful life of the item and determining what percentage of that
life remains. This percentage multiplied by the replacement cost equals the ACV. For example, the
television set you purchased five years ago for $2,000 was recently destroyed in a house fire. Your
insurance company calculates that all televisions have a useful life of 10 years. A similar television
today costs $2,500. The destroyed television had 50% (5 years) of its life remaining. The ACV equals
$2,500 (replacement cost) times 50% (useful life remaining) or $1,250.
Replacement Cost Value (RCV)
Replacement costistheactual costtoreplace anitemor structureatitspre-loss condition.Thismaynot
be the "market value" of the item and is typically distinguished from
the ACV method which includes a deduction for depreciation. For
example, what happens if a burglar steals your six-year old television
set? With actual cash value coverage, you get only what you would
expect to pay for a six-year-old television set. With replacement cost
coverage, the insurance company pays to replace your TV with a new
set similar to the stolen one.
Market Value
Market value is what the property could be sold for. This is different from
replacement value. The replacement value is what the insurance company would
pay to rebuild the home in case of a total loss. As an example, if you purchased
a home in a depressed market for $200,000 and the house burned down, it may
take $275,000 in building materials and labor costs to replace it. The market value
is currently $200,000, but you would want to insure the house for the full $275,000
to replace it.
Stated Value
Stated value coverage pays the cost to repair an insured item or the stated value of the insured item,
whichever is less. For example, when you purchase a homeowners policy, you will be asked the value
of your personal items such as furniture, clothing, appliances, lawn mower, tools, etc.
If you report a value of $100,000, that becomes your stated value. But, if a loss occurred, you will
have to show proof that you lost that much and the insurance company certainly has the right to
dispute your figures.
Salvage Condition
This condition allows the insurance company to settle with you by taking possession of the damaged
property, then paying the full loss amount. After the insurance company sells the salvaged property,
the proceeds can reduce the cost of the claim to the insurance company.
For example, you have an auto accident that totals your car. Your insurance company considers it a
total loss. After the company pays the claim, they sell the car to a salvage dealer. The proceeds from
the sale will help offset the claim paid.
Adverse Selection
Oneofthefunctionsoftheunderwritingdepartmentistoprotecttheinsurerfromadverseselection.
The concept of adverse selection suggests that the people who are poor risks are more likely to
purchase insurance than average risks.
For example, someone just diagnosed with cancer would probably want to purchase a cancer policy
if possible. If the person's doctor tells them that they will die from the cancer within 6 months, the
person may want to purchase additional life insurance too. In these cases, the insurance company
would not sell a policy to the person for obvious reasons.
Conversely, healthy people tend to delay purchasing insurance, or shop less often.
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