1 chapter 10 risk management. 2 chapter goals evaluate risk management as an overall household...

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Chapter 10

Risk Management

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Chapter Goals

Evaluate risk management as an overall household approach.

Distinguish the types of risk that people are exposed to.

Demonstrate how risk modification leads to improved financial management.

Analyze the central role insurance plays in reducing risk.

Establish the common types of insurance available. Compare whole life and term insurance.

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Risk Management Theory

Risk management in theory can be viewed as the study of methods for controlling portfolio risk.

The goal is to have the highest quality of life possible, given your tolerance for risk.

There is no grouping of assets or other techniques that can fully eliminate risk in your portfolio, primarily due to the lack of a full hedge for human assets.

Products with negative correlation are costly. Further, human assets such as unemployment and

health insurance are available, but do not control all risks.

Further, we cannot hedge away overall market risk.

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Risk Management Theory, cont.

Risk management techniques are methods of modifying a household's portfolio risk.

An overall portfolio risk is established, and current portfolio risk is compared preference for risk.

The most efficient risk management technique is then selected to bring the portfolio in line with tolerance for risk.

In revising the portfolio one establishes a risk/return strategy that attempts to optimize portfolio income and brings about the highest standard of living possible.

This approach is a part of the foundation of Total Portfolio Management.

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Risk Management in Practical Terms

In practice, we are only concerned with outcomes that are below expectations as these are the outcomes that produce losses.

Risk management in practical terms is defined as the process by which we identify risks and control them so that we are able to achieve individual goals.

When engaged in financial planning, you must first identify risks knowing that losses in any one area can jeopardize overall household goals.

Then, the ways of dealing with the risks should be considered and the most efficient method selected.

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The Risk Management Process

The six stages of he risk management process are as follows:

1. Develop objectives: Select one area or examine all household risks?

2. Establish exposures: Each area of household assets has its own risks.

– Financial assets.– Nonfinancial assets, both human related and real.

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The Risk Management Process, cont.

3. Identify available risk management tools: Eight risk management approaches are:

– Avoid risk: Seek to eliminate exposure to risk. – Reduce risk: Seek to lessen risk. – Reduce potential loss: Lessen damage if a loss occurs.– Retain risk: Rejects the possibility of reducing or eliminating risk,

but instead decide to absorb the potential loss yourself. – Diversify: Assets are diversified so that the impact of an

unfavorable outcome for any one asset is reduced. – Transfer risk: Transfer risk to someone else.– Sharing risk: When you transfer some risk and retain a part of it

called that sharing risk. – Other methods of handling risk: These include options, futures,

and swaps. Hedging transfers business risk to a third party.

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4. Match appropriate risk management tools to exposure: Different exposures call for separate risk management tools. Factors to consider:

– The cost of alternative risk management techniques.– The amount and likelihood of loss. – Convenience factors.– Risk tolerance.

Let’s look at the exposures by category and describe the risk management tools that apply.

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Human-related assets: Risks include:– Longevity – Premature Death

Longevity risk is the possibility of living beyond normal expectations or dying prematurely.

– Longevity – Extended Life An extra long life can result in a decline in your standard of living or

running out of private funds.

Source: National Vital Statistics Reports.

Year All deaths Death rate Life expectancy

2002 2,447,864 846.8 77.42001 2,416,425 854.5 77.22000 2,403,351 872.0 77.01990 2,148,463 938.7 75.41980 1,989,841 1,039.1 73.71970 1,921,031 1,222.6 70.81960 1,711,982 1,339.2 69.71950 1,452,454 1,446.0 68.21940 1,417,269 1,785.0 62.9

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– Health and disability: expenses for sickness and inability to perform at your job.

– Macro and microeconomic risks: Macroeconomic risk: The risk inherent in the general economy. Microeconomic risk: The risk associated with the individual industry or

company. Precautionary savings for such an event, government-supplied

unemployment insurance, and diversification through an increase in the number of household members who work can all reduce economic risks related to your job.

– In addition to your job income, there are human assets that are derived from your rights and relationships.

Risks can be reduced through diversification of savings. Inflation risk from flat business pension payment can be reduced through inflation-indexed bonds.

Maintaining close relationships enhances the potential for gifts and bequests at the death of a loved one.

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Real assets: Tangible assets that the household owns. – Safety measures to prevent or reduce perils help. – Many houses carry homeowners’ insurance. – Other valuable assets such as jewelry may be insured

separately or are self-insured. Financial assets: The ownership of assets that are

typified by pieces of paper and are often marketable. – Risk can be covered by diversification strategies.

Liabilities: Monies owed to others. – Reducing debt, placing caps on rates borrowed when they are

available, and accumulating precautionary savings can serve to reduce this risk.

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Intangible liabilities: Less quantifiable current liabilities such as potential liabilities to third parties.

– Care of personal property and safety precautions can be employed.

– Umbrella insurance can cover myriad types of lawsuits.– Professional liability insurance can help protect you in our

increasingly litigious society. – Education about individual exposures to third-party risk and

what to do to avoid them can reduce your risk.– Maintenance expenses can also be thought of as

obligations and intangible liabilities.

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5. Implement: Implementation is taking the action step. – Setting an implementation plan with specific dates to

accomplish tasks can help avoid procrastination.

6. Review: Risk management exposures can change. – It is a good idea to review exposures at least once a year.

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Insurance

Insurance is a method of transferring risk. Risk is shifted from the person exposed to it to the insurance company that assumes the risk for a fee.

The insurance company assumes the risk after selecting whom to insure, which is called insurance underwriting.

By using scientific methods, the company can estimate its exposure to loss and charge enough to make a profit.

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Insurance, cont.

If insurance products were fully efficient, the amount you paid for insurance would be exactly equal to the expected value of the loss.

Under that assumption every risk-avoiding person would select insurance as the insurance would provide a hedge against risk at no extra cost.

But insurance products are not fully efficient in a financial sense due to:

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Insurance, cont.

Overhead Costs. Incomplete Information.

– Moral hazard is the increased chance of loss due to policy holder extra risk arising from such things as undisclosed illness or faking injury after the policy is taken out.

– Adverse selection refers to people who have greater chance of loss, purchasing more insurance than they would normally do because of knowledge of their health that the insurance company does not possess.

Search costs: Costs that the person desiring to be insured undertakes to find out which policy is best.

Behavioral factors: Evidence suggests that humans may not always act efficiently in risk management activities.

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Types of Insurance Policies

Personal: – Life: Provides monies to others at the death of the insured.– Disability: Makes payments to replace income of the insured

once the person is incapacitated. – Long Term Care: Payment provided generally to the elderly,

which assists those unable to care for themselves due to physical or mental conditions.

– Health: Reimburses health-related expenditures. Property:

– Property and Casualty: Pays for losses to home and possessions, and coverage for exposures to third-party losses.

– Personal Liability: Extends coverage for liabilities of many types of a personal nature.

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Types of Insurance Policies, cont.

Government: – Unemployment: Supplies income for a specified period

upon job termination. – Social Security: Provides income, disability, and medical

reimbursement after retirement. And in the event of premature death will provide payments to spouses, children, and parents being supported.

Other: – Welfare, food stamps, and medical preretirement: Allows

support for lower income Americans.– Long-term care and nursing home assistance: Issued

principally for support for disabled Americans, generally with few assets.

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Insurance Providers

There are three major types of providers of insurance to individuals:

– The government. The government tends to concentrate in items with widespread exposures by cross-sections or individual strata of society.

– Private group policies: Associated with low marketing costs, mass volume efficiency, and reduced screening and administrative costs. There may be tax advantages and company subsidization as well.

– Private individual policies: Flexible and portable.

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Analyzing an Insurance Company

Criteria include:– Financial strength: Best, Standard and Poors, Moody's and

other agencies evaluate and rate an insurer's finances. – Good operating sense: Measures how wise the company is

in selecting risks it is willing to underwrite and how efficient it is in running its business and processing its claims.

– Service: How good is the company’s service and does it pay out promptly and fairly on claims submitted?

– Price: Price should be compared with quality to obtain the best value. Pay particular attention to financial strength.

– Other considerations: These include company size, duration in business, specialization, location, and others.

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Insurance as an Asset

Insurance can be viewed as an asset as owning insurance can actually lead to higher net revenues.

If insurance reduces risk in one area, it can allow greater risk-taking in another area.

For example, a business that is able to hedge currency risk at an acceptable cost may go forward in a highly profitable overseas investment whereas it wouldn’t do so otherwise.

Similarly, someone who is adventurous may be able to purchase life and disability insurance and then undertake a somewhat risky but lucrative overseas job assignment.

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Summary of Risk Management and Insurance

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Summary of Risk Management and Insurance, cont.

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Life Insurance Goals

Life insurance compensates for the death of a household wage earner.

Its payments most frequently are made to other current or former members of the household after the death of the insured, who paid for the policy.

Life insurance is negatively correlated with human assets, specifically, with the risk of premature death.Type of Life Insurance Face Amount (in billions) (as percentage of total) Term Insurance $7,828 55% Whole Life $2,535 17% Universal Life $2,582 18% Variable Life $1,282 9% Other $13 1% Total $14,240 100%

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Parts of an Insurance Policy

Mortality Charge. The insurance company: – Diversifies through large numbers of policyholders;– Calculate the probability of death for any group of insurance

holders and place that as one cost in the policy. – Engages in a screening process for insurance applicants.

Investment Return. – In the early years of a typical whole-life policy, the annual

premiums far exceed the mortality cost, providing the policy with extra cash to be invested. The return on this investment helps pay the mortality costs in later years, when these costs can far surpass the annual premiums.

Overhead Expense.– Include the cost to market the product, to maintain the policy, and

company profits.

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Amount of Insurance

Three approaches through which we can determine the amount of insurance needed are:

Income replacement: – The amount of insurance is should to cover the loss of

income. – Equal to the present value of the lost income over a

person’s remaining life expectancy on an after-tax basis, plus any funeral expenses.

Life insurance needs: – Calculate the requirements of the other members of the

household in the event of the death of a wage earner.

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Amount of Insurance, cont.

– Life insurance needs are adjusted for: Decline in living costs caused by the less household members Future education costs for children Repayment of the mortgage to reduce overhead costs and

insurance needs resulting from decline in living costs.– The calculation of the appropriate amount of insurance

under an insurance needs analysis projects income expense and shortfalls by period.

Partial Replacement:– The household may only fund for a more modest life style,

or provide enough cash to educate a spouse so that he or she can generate higher wages, or just provide resources for a period of time until another marriage is assumed to have taken place.

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Term Insurance

Term insurance: Life insurance providing fixed coverage for a stated period of time with policyholder premiums that vary based on the possibility of death of the insured during that time frame.

Premiums are principally based on mortality cost and life insurance company overhead.

Little asset value other than that for the probability of death at any given age multiplied by the amount of insurance for the period of coverage remaining.

Renewable term guarantees that the policy will continue in force, regardless of the health of the insured for a stated period of time.

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Term Insurance, cont.

Convertible term allows the insured to swap a term policy in the future for a whole life policy, regardless of the insured's health at the time.

Reentry is the requirement that you pass health tests at stated times to qualify for the annual rates given in the policy.

Some policies pay dividends. Term policies pay out death claims much less often

than most other forms of life insurance due to the combination of term being used for limited periods of time over the life cycle and usually expiring by age 70.

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Term

Whole Life

Whole Life

Whole life: Life insurance providing fixed coverage for the life cycle of the insured.

– Payments for whole life insurance are level over the life of the policy.

– Level payments are possible despite higher mortality costs over time because payments in early years are higher than policy needs.

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Whole Life, cont.

Annual payments in excess of mortality and overhead costs are placed in a cash value account.

The cash value can be withdrawn less some redemption charge or borrowed against.

The cash flow process for life insurance:

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Universal Life Insurance

Universal life combines term and whole life since it has both term like charges and a side fund which receives an investment return intended to pay term insurance premiums.

If payments and existing cash value are not sufficient to meet current insurance company needs, insurance coverage can be reduced.

Insufficient payment does not automatically result in cancellation of the policy.

If policy projections are not met the extra cost is shifted to the policyholder through additional insurance payments.

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Variable Life

Variable life is similar to whole life except that it transfers the investment function from the insurance firm to the individual.

Individuals may select the proportion of stocks or bonds they would like and the types of funds within each category.

The choices can be limited to monies managed by each insurance company or may include outside money manager.

If the funds have poor performance, greater premium payments may be needed or coverage could be jeopardized.

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Variable Universal Life

Variable universal life combines the payment flexibility of universal life with the investment flexibility of variable life.

It offers both the choice of time and amount of premium payments, as well as the opportunity to select bond or stocks funds, frequently with a choice within category.

On the other hand, it can be difficult to determine the adequate level of funding.

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Term as Compared with Whole Life Policies

Strengths of term:– Pure insurance, risk management is the prime intent.– Unlimited flexibility in investment options associated with buying term

and investing the difference.– Highly competitive pricing.– Relatively easy to compare policies against one another.– Flexibility in reducing or eliminating coverage efficiently.

Weaknesses of term:– Rates rise over time until they are prohibitively expensive.– Potential underinsurance if individuals do not buy term and instead

invest the difference. – Some policyholders are uncomfortable with what can be significant

payments without continuing values.– Susceptible to moral hazard and adverse selection, particularly if there is

no re entry provision.

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Term as Compared with Whole Life Policies, cont.

Strengths of whole life:– The premiums remain level over time and thus aren’t

unaffordable in later years.– Higher payments than needed to cover mortality risk are an

effective "forced savings" component for those who need it.– The amount in the cash value account that is built over time is tax

sheltered. No taxes are paid unless the policy is surrendered.– Cash values accumulated can be borrowed against to help

finance retirement– Monies spent in premiums can provide a tangible cash benefit

over time, not a pure expense as in term.– The policy is designed to commonly pay a cash benefit to the

beneficiary in contrast to term’s less frequent payout as temporary insurance.

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Weaknesses of whole life:– The costs for full coverage for young people on limited

incomes can be very high– The investment element of whole life, the cash value

accumulated, is only available while the person is alive. The amount paid out at death is just the insurance amount, not the insurance amount plus the cash value.

– Policies are difficult for the average person to compare.– Non tax-deductible interest is charged on amounts borrowed

on cash value.– Termination of the policy in early years generally provides

little or no cash value, making it an inefficient investment for many years. (Approximately 20 percent of the policies are cancelled in the first two years.)

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On balance, decisions should be made based on:– How long the policy is to be held. Term, which has no cash

value, may be most competitive for periods of 10 years or less; whole life should be held for at least 10 years.

– Whether in fact the "difference" is saved, not spent, when buying term and investing the difference.

– The buyer’s risk tolerance for investments. Those with low risk tolerance are more likely to find whole life returns attractive than are those with a high tolerance for risk.

– The actual difference in return between a whole life policy and the investment alternatives available to the policyholder.

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Chapter Summary

Risk management is an overall household approach which identifies and controls uncertainty. It eliminates obstructions to goal achievement.

Common risk management approaches are to avoid risk, reduce risk, reduce potential loss, transfer risk, share risk.

Common human asset risks are shorter and longer life spans, health and disability, macro and microeconomic risks.

Insurance transfers specific asset risk and in doing so modifies overall household portfolio risk.

Insurance can be separated into personal, property and government categories.

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Chapter Summary, cont.

When analyzing an insurance company, the following factors are important: financial strength, good operating sense, price, and service.

There are five main types of life insurance – whole life, term, universal life, variable life and variable universal life.

Term insurance is pure mortality insurance. Some advantages of term are: highly competitive,

easy to compare, flexibility in reducing coverage. Whole life combines mortality with a savings feature

through prepayments.

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Chapter Summary, cont.

Whole life advantages are level premiums over time, forced savings for those who need it, cash values accumulated which can be borrowed against.

Choosing term vs. whole life depends on such factors as how long the policy is being held, need for forced savings, and effectiveness of investing on your own.