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Risk Management (Part 2 of 8)

>> Wednesday, February 10, 2010

Risk management in financial planning is the systematic approach to the discovery and treatment of risk.

The objective is to minimize worry by dealing with the possible losses before they happen.

The process involves:
Step 1: Identification
Step 2: Measurement
Step 3: Method
Step 4: Administration

Risk Identification
The process begins by identifying all potential losses that can cause serious financial problems.
(1) Property Losses - The direct loss that requires replacement or repair and indirect loss that requires additional expenses as a result of the loss.
(For example, the damage of the car incurs repair cost and additional expenses to rent another car while the car is being repaired.)
(2) Liability Losses - It arises from the damage of other' property or personal injury to others.
(For example, the damage to public property as a result of a car accident.)
(3) Personal Losses - The loss of earning power due to death, disability, sickness or unemployment and the extra expenses incurred as a result of injury or illness.
(For example, the loss of employment due to cancer and the required treatment cost in addition to normal living expenses.)

Risk Measurement
Subsequently, the maximum possible loss (i.e. the severity) associated with the event as well as the probability of occurrence (i.e. the frequency) is quantified.
(1) Property Risk - The replacement cost necessary to replace or repair the damaged asset is estimated by a comparable asset at the current price. Indirect expenses for alternative arrangements like accommodation, food, transport, etc, needs to be taken into account.
(2) Liability Risk - This is considered to be unlimited as it will depend upon the severity of the event and the amount the court awards to the aggrieved party.
(3) Personal Risk - Estimate the present value of the required living expenses and additional expenses per year and computing it over a predetermined number of years at some assumed interest rate and inflation.

Methods Of Treating Risk
A combination of all or several techniques are used together to treat the risk.
(1) Avoidance - The complete elimination of the activity.
This is the most powerful technique, but also the most difficult and may sometimes be impractical. In addition, care must be taken that avoidance of one risk does not create another.
(For example, to avoid the risk associated with flying, never take a flight on the plane.)
(2) Segregation - Separating the risk.
This is a simple technique that involves not putting all your eggs in one basket.
(For example, to avoid both parents dying in a car crash together, travel in separate vehicles.)
(3) Duplication - Have more than one.
This technique requires preparation of additional back up(s).
(For example, to avoid the loss of use of a car, have 2 or more cars.)
(4) Prevention - Forestall the risk from happening.
This technique aims to reduce the frequency of the loss occurring.
(For example, to prevent fires, keep matches away from children.)
(5) Reduction - Minimize the magnitude of loss.
This technique aims to reduce loss severity and can be used before, during or after the loss has occurred.
(For example, to reduce losses as a result of a fire, install smoke detectors, sprinklers and fire extinguishers.)
(6) Retention - Self assumption of risk.
This technique involves retaining the risk consciously or more dangerous as unconsciously to finance one's own loss.
(For example, having 6 months of income in savings to protect against the risk of unemployment.)
(7) Transfer - Insurance.
This technique transfers the financial consequences to another party.
(This will be covered in more detail as a topic.)

Administration Of Method
The selected methods must be implemented. A combination is most effective and below is only a guide for the most logical techniques to be used for the types of risk:

 

And finally to close the loop for the process, new risks must be continually identified and all risks needs to be re-measured when required. Treatment alternatives should also be reviewed.

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