What is Risk? How to Manage Risk?

Photo by Markus Winkler on Unsplash

Author: Andrew Lee
About 2  minutes read.

In Insurance world, risk are categorized into speculative risk and pure risk. Speculative risk means you have a chance of gain, however, pure risk only has a chance of loss. Consider speculative risk is like going to Casino to gamble, you could win or lose, and pure risk is like the chance of getting sick or hit by a bus. Generally speaking, Insurance only insures pure risk. 

Hazard is either a physical event/behavior that could increase the risk such as smoking or a fire hazard. It could also be a moral hazard due to dishonesty, or morale hazard for careless (e.g. mindset of I don't care because I am insured).

Basically, insurance company applies the Law of Large Numbers along with other elements to see if something is insurable such as "due to probability", measurable and definite on the loss, statistically predictable, not catastrophic (e.g. pretty much your insurance contract excludes war or have some words for act of God), and randomness. These are how insurance company come up with their cost and premium as well derived from actuarial science.

So, how do you manage risk? Basically, there are few ways to address risk depending on what type of risk you are trying to handle.

• Avoid - just don't do it! it is that simple. But not all risk can be avoid (e.g. getting sick, or death).

• Reduce - more on preventive side such as installing smoke detectors, perform annual checkup, etc. to address them early on or control the risk which means reducing potential hazards.

• Retain - self-manage the risk. Basically take on the risk with what you got in your limit.

• Transfer - transfer the risk to other party, aka insurance contract.

Alright, you may be thinking now how do I handle risk or how to transfer them because some risk are not transferrable or avoidable such as illness, disablement, injury, etc. and it won't be realistic to transfer them such as death. In insurance world, the definition is straight forward. Insurance is a way to relieve your financial loss, or to hold insured harmless, or some other agreements to restore the insured to the original status. Here, death is converted to death benefit, disablement could be treated with technology if possible and insurance could cover the expense for such operation or provide income replacement, and if somebody sues the insured, insurance company could involve in the trial to provide necessary resources and covers the damage from the lawsuit.

Today, most people fall into the self-retain category. If something happens, you will liquidate your asset, resource, and network to restore yourself to your original status. However, this does not mean retention (self-retain) is not for you or your company. It depends. You need to understand the risk you are facing and decide on a suitable method to handle and manage it. 

I always make this joke when I talk about auto-insurance 3rd party liability in California. Do you prefer to put $35,000 on the side as a surety bond with the DMV or pay few hundred dollars a year and keep the remaining ~$34,500 in some other investments or savings (assuming a reasonable priced car, not a super fancy exotic car)?

You can do the math. This is just an example based on opportunity cost. However, it is always more complex than it sounds.