Step 2: Estimate Risk and Potential Losses. Once You Identify Your Exposures To Risk

Step 2: Estimate Risk and Potential Losses.
Once you identify your exposures to risk,

you
estimate both loss frequency and loss severity. Loss frequency refers to the likely
number of times
that a loss might occur over a period of time. Loss severity describes the potential
magnitude of
the loss(es). Many people wonder whether they should buy insurance when loss
frequency is low,
for example if they are young and healthy or if they live in a safe neighborhood. This
is not a good
way to think about potential losses. If loss frequency is low, the insurance would
simply cost less.
Step 3: Choose How to Handle Risk. The risk of loss may be handled in five ways: risk
avoidance, risk retention, loss control, risk transfer, and risk reduction. Each strategy
may be
appropriate for certain circumstances, and the mix that you choose will depend on
the source of the
risk, the size of the potential loss, your personal feelings about risk, and the financial
resources you
have available to pay for losses.
• Risk avoidance. The simplest way to handle risk is to avoid it. With this approach,
you
would refrain from owning items or engaging in activities that expose you to possible
financial loss. For example, choosing not to own an airplane or not to skydive limits
your
exposure. Avoiding risk is not always practical, however.
• Risk retention. A second way to handle risk is to retain or accept it. The risk that the
shrubbery around your house might die during a dry spell is such a retained risk.
Conscious risk retention plays an important role in risk management. Risk retention
due to
ignorance or inaction is not effective risk management. For example, many people
unwisely put off the purchase of life insurance because they consider it to be a
morbid,
unpleasant task.
• Loss control. Loss control, the third method of handling risk, is designed to reduce
loss
frequency and loss severity. For example, installing heavy-duty locks and doors will
reduce the frequency of theft losses. Installing fire alarms and smoke detectors cannot
prevent fires but will reduce the severity of losses from them. Insurance companies
often
require loss-control efforts or give discounts to policyholders who implement them.
• Risk transfer. A fourth way to handle risk is to transfer it. In a risk transfer, an
insurance
company agrees to reimburse you for a financial loss. For example, a professional
football
team’s star run uncertainty is simply transferred from the running back or his team to
an
insurance company. Insurance represents one method of transferring risk, although
not all
risk transfers can be classified as insurance because insurance goes beyond merely
transferring risk to the actual reduction of risk.
• Risk reduction. The fifth way to handle risk is to reduce it to acceptable levels.
Insurance
is used by policyholders when they arrange for all or a portion of their risk to be
covered by
an insurance company, thereby reducing their personal level of risk.
Step 4: Implement the Risk-Management Program. The fourth step in risk
management is to
implement the risk-handling methods you have chosen. For most households, this
means buying
insurance to transfer and reduce risk. This involves selecting types of policies and
coverage, dollar
amounts of coverage, and sources of insurance protection. People often wonder
what types of
insurance to buy and how many dollars of coverage to choose. You should use the
maximum
possible loss as a guide for the dollar amount of coverage to buy. This way of
thinking makes use of
the large-loss principle: Insure the losses that you cannot afford and assume the
losses that you
can reasonably afford. In other words, pay for small losses out of your own pocket
and purchase as
much insurance as necessary to cover large, catastrophic losses that will ruin you
financially. The
example earlier of an auto accident that injures a heart surgeon would bring you such
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3
you would be held responsible for those losses. Consequently, you would want high
dollar amounts
of liability coverage on your auto insurance.
Step 5: Evaluate and Adjust the Program. The final step in risk management entails
periodic
review of your risk management efforts. The risks people face in their lives change
continually.
Therefore, no risk-management plan should be put in place and then ignored for long
periods of
time. For certain exposures, such as ownership of an automobile, an annual review is
appropriate.
For areas involving life insurance, a review should occur about once every three to
five years or
whenever family structure and employment situations change. The necessary
adjustments should
be implemented promptly to reflect changes over your life cycle. Many people stick
with existing
policies that no longer fit their needs (too little or too much coverage) simply because
they buy once
and ignore their insurance needs for years.

Step 2: Estimate Risk and Potential Losses. Once You Identify Your Exposures To Risk

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Step 2: Estimate Risk and Potential Losses. Once You Identify Your Exposures To Risk

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Step 2: Estimate Risk and Potential Losses.

Once you identify your exposures to risk,

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