By Ashlee Ogrzewalla, CFP®, Vice President and Manager of Financial Planning & Marketing
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There are many things in this world that can cause financial harm, and exposure to harm from these events is a risk. Though many people are aware of risks in financial markets, fewer consider financial risk in its broader perspective.
The Realms of Risk
Beyond the notion of investment risk, financial risk can be apportioned into three main categories as it applies to our financial lives: health risk, property risk and earned income risk.
- Health Risk: Medical care can be costly. An injury or illness is a real risk, and a significant medical event could have major financial consequences.
- Property Risk: Losses can occur due to theft, fire and other events. In addition to the risk to property, liability risk with that property is also a concern. Owners could be found liable for damages to others.
- Earned Income Risk: Generally, the ability to earn an income is one of the greatest assets an individual has. Sickness or injury can cause financial health to suffer dramatically when it affects one’s ability to earn an income.
Ways to Manage Risk
There are three basic ways to manage the potential consequences of financial risk:
- Retain the Risk: Retaining risk can make sense if the consequences are relatively minor and there isn’t a worry about loss or damage because the items are replaceable without significant hardship.
- Mitigate the risk: You can mitigate risk by taking actions that reduce the likelihood of damage or injury; for example, driving carefully or installing a burglar alarm. Both choices mitigate risk by reducing the probability of loss.
- Transfer the Risk: Transferring risk makes sense for events with low probability and high cost. Life insurance for yourself and your loved ones is an excellent example. The risk of unexpectedly losing a young and healthy person is relatively low. Still, the loss of income and stability is more than most families could easily bear, so transferring the risk, or at least the bulk, to a life insurer is the best option.
In some cases, a combination of methods may be appropriate. Often, people retain a small risk while transferring a significant risk: an insurance deductible for property insurance being the risk we retain, then transferring the remaining risk to an insurer.
Managing our non-investment risk is essential to planning for a financially healthy future. The fundamental aspects that define risk management are its potential cost and the probability of the risk occurring. This approach to evaluating risk will help assess the potential for loss. Consider the alternatives available, the probability of a negative occurrence and the cost of the occurrence should it arise. When the cost isn’t easily absorbed through emergency funds, consider other options, such as insurance, to reduce exposure to financial harm.
IMPORTANT DISCLOSURES: The information provided is based on internal and external sources that are considered reliable; however, the accuracy of this information is not guaranteed. This piece is intended to provide accurate information regarding the subject matter discussed. It is made available with the understanding that Benjamin F. Edwards is not engaged in rendering legal, accounting or tax preparation services. Specific questions on taxes or legal matters as they relate to your individual situation should be directed to your tax or legal professional.