Tuesday 6 May 2008

How I gave my personal financial risk management plan a check-up

A personal financial risk management plan is an important tool to help assure that I've adequate protection in place to look after myself and my family in the event that my assets or earning ability are impaired. Most people never develop a plan for managing financial risks, but it's actually not too difficult or time consuming to put a basic plan into place. Without a plan, you might:
  • be over-insured in some areas and under insured in others.
  • be unaware of the risks to which you are exposed.
  • be insuring risks that are more emotional than financial in nature.

I spent about 30 minutes using a free, online tool from the university of Illinois to sketch out a rough financial risk management plan.

The tool helps you to:
  • identify those events which pose a financial risk to you or your family.
  • learn the four basic methods of managing risk.
  • determine which methods you are currently using to manage your risks.
  • identify gaps in your current risk management strategies.
The first step of the tool asks you to rate (on a scale of 1-4) a list of typical financial risks in terms of financial severity (ignoring any insurance you already have to mitigate the impact) and probability/frequency of the event happening. In my case the first step produced a simple graphical grouping showing which risks need to be addressed (the high impact/high probability ones), those that may be worth addressing (high impact but low probability), those where the risk can be absorbed more economically than insured against (low impact and high frequency risks), and those that can be ignored (low impact, and unlikely events).

This risk matrix will vary depending on your personal situation. The website gives the example of the risk of death - low probability but high impact for a young breadwinner with a dependant family, compared to high probability but fairly low financial impact for a 90-year-old with no dependants.

The next step looks at the various ways you can choose to handle risks. The website uses the example of an event (totalling your car) to illustrate the four general approaches to handle the risk:

1. Bear the risk: You drop the collision insurance on your ten year old car. You continue to drive it regularly.

2. Transfer the risk: You buy collision insurance on your car so that the insurance company bears the risk of having to replace or repair your car.

3. Reduce or control the risk: You wear seat belts, which would reduce your injury in the event of an accident, and you do not speed, which reduces the likelihood of an accident.

4. Remove the risk: You sell the car and use public transportation.

The website provides nine simple examples of risk handling decisions for you to check that you understand the four approaches.

Step three then goes on to help you identify which of the four approaches you are currently using to handle your financial risks. It then explains how the different techniques for handling risks will be appropriate depending on the probability and degree of financial severity, and puts this into the same sort of matrix that you previously developed for your risk assessment:

The website tool then goes on to tabulate the most appropriate methods for handling each of your risks, based on the way you rated them on financial severity and probability. "You may be surprised by some of the recommendations. For example, you may have believed that everyone needs life insurance. But if your death would have a low financial impact or if the probability of your death is high, you will see that techniques other than transferring (insuring) are recommended. Under this framework, only someone whose death would pose a financial hardship (such as someone who has dependent children) and for whom death is unlikely should insure his or her life. Others should be using different techniques, such as setting aside enough money to pay for your burial (bearing the risk) and seeking ways to reduce the size of the financial risk, such as structuring your estate so that a family business won't have to be sold to pay estate taxes."

Hopefully, this tool will provide a useful check-up of your existing financial risk management plan.

Copyright Enough Wealth 2008

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