Risk is inherent in all aspects of our daily lives, yet is an often overlooked piece of the financial puzzle.
Oftentimes, you’ll hear financial risk management strategies applied to business operations and investments, this is because risk management is so important to the survival and success of businesses and investment portfolio; its importance, however, is rarely emphasized to individual personal financial planning, and while business and investment growth are important, personal financial conservation and success equally is, and that is the focus of this article.
- Understanding Risks
- Types of Risk
- Loss of Asset in Personal Finance
- What is Financial Risk Management
- Four Types of Financial Risk Management Strategies
- How Risks Affect Your Personal Finance
- The Cost of Risks
- The Objective of Risk Management
- Importance of Financial Risk Management
Risk is the possibility of loss, in most cases, of an asset that could potentially cause financial hardships to an entity, individual, or family.
As an economic being, you may own a lot of assets, some are important, some aren’t as important.
There are a lot of different risks that may affect ones’ financial well-being, due to loss of one or more assets.
Driving to and from work on a daily basis, for example, presents a lot of risks to you, your loved ones and your vehicle.
In Canada, you can’t drive a vehicle without insuring it and you have to go through a stringent driver-licensing certification before you could operate one as a licensed-driver.
That’s because taking a vehicle on the road presents such a high-risk to yourself and others.
Should something happen on the road, a lot of assets and lives are at risk. To protect yourself against the financial obligations of such a risk, proper driver certification and the implementation of auto insurance is the most sensible thing to do.
By implementing auto insurance, you’re sharing the risk to another entity, which in this case is an insurance company, so you won’t have to assume all the financial risk of such a loss that may result due to an accident or vandalism.
Yesterday, for example, I went to AUTOPAC (Manitoba owned auto insurance provider) for an estimate because my SUV’s rear glass panel was vandalized (i.e. shattered to pieces) just a couple of nights ago; the total cost to replace the glass and repair a small dent near the hatch came to about $1,700.00. If I didn’t have insurance on my vehicle, I would have assumed this loss, since I have insurance in place, I “shared” or “transfer” the risk to another entity, which in this case is the insurance company.
I used a car as an example because every law-abiding Canadians, insure their car, one because of the high perceived value, secondly, because it’s required by law. Inside the car though, there’s a more valuable asset, no it’s not your purse or smartphone… it’s you and your loved ones!
Unfortunately, very few Canadians, actually think of implementing an effective risk management strategies to the most valuable assets inside their vehicles or their homes. Most of us would insure every other assets or possessions that we have, instead of ourselves.
Effectively managing your personal financial risks sets out the foundation of your financial security and future; so whether you’re a self-employed professional, a business owner, or an employee, implementing an effective personal risk management strategy is very important in protecting your bottom line.
There are various types of risk management strategies available in personal finance, by default, most people assume the financial impact of certain risks, unaware of the fact that they can actually mitigate or minimize the financial impact of such risks by sharing or transferring the risk to someone else.
The purpose of managing your personal financial risks is to protect your financial well-being, assets, goals, dreams and loved ones from the “what-ifs” of life so you or your loved ones’ won’t have to find yourselves in a “what now” situation when the “what if” may have already happened.
When the risk is low and isn’t too costly, it’s easy to assume it. When the risk is high and too costly, it’s stupid to assume it.
You need other ways to manage such a risk, sharing or transferring the risk to someone else may be a convenient option.
Insurance provides an effective way of mitigating the financial impact of a catastrophic event.
Types of Risk
Generally, there are two types of risks, namely, “pure risk” and “speculative risk“.
Pure Risk, is a type of risk wherein you can only incur loss in case a certain event occurs.
For example, flood damage.
In case a flood occurs in your area, your house will either be damaged or not. This type of risk is usually insurable.
Speculative Risk is a type of risk wherein certain events may result to a gain, loss, or even (stays the same).
This type of risk correlates to investments, business, and gambling wherein a person takes a certain level of risk with the aim of achieving speculative growth. This type of risk is generally uninsurable but there are ways to hedge against this risk to mitigate or minimize your losses.
Loss of Asset in Personal Finance
If risk is defined as the possibility of loss, what asset can a person potentially lose which could result to financial hardship?
As an economic being, you may own a lot of assets, some are important, some aren’t as important, so it’s a matter of prioritizing, which among your assets are the most important that losing such may result to financial hardship.
An asset, as defined in dictionary, is a:
“property owned by a person or company, regarded as having value and available to meet debts, commitments, or legacies.”
In other words, an asset is anything that you own or possess that puts money in your pocket.
If you’re an employee, your job, (love it, or hate it), is an asset. If you’re self-employed or a business owner, your business or career is an asset.
Some people think that material possessions like the house they live in, cars, electronics, and furniture are their most important assets, and agreeably, losing these assets can result in some sort of financial losses.
If a Smart TV, say for example that costs $5,000.00, breaks down after 1-year, and you haven’t implemented extended warranty insurance, this will result to a financial loss, since having it repaired or replaced will cost you money but this is not the kind of asset that we’re talking about here, most people do hedge against losing these asset type but fail to hedge against losing their most important asset.
So what is your most important asset?
If you’re like most of us and you actively work for income either on a business, profession or a job, your most important asset is your ability to work for income; the potential risk of losing this ability may result to drastic financial losses or hardships to you and those who depend on you for financial support.
Most people don’t realize the amount of financial risk associated with the possibility of losing their ability to work for a living, so by default, they tend to assume the financial impact which may result to losing such.
Think about this for a moment, if you suddenly find yourself in a situation where you’re unable to actively work for income, and you don’t have an effective risk management strategy in place, what would you do?
Will you and your loved ones be able to afford the same lifestyle?
Will you and your loved ones not struggle financially?
Will your wealth-accumulation plans remain intact and unaffected?
If you answered, “Yes” to these, then you are already effectively managing your risks, if not, continue reading!
What is Financial Risk Management
In business, financial risk management is defined as:
“The forecasting and evaluation of financial risks together with the identification of procedures to avoid or minimize their impact.”
In personal finance, financial risk management is the process of applying risk management principles to the needs of individual consumers. It is the process of identification and analysis of personal risk and the acceptance or mitigation of the financial impact thereof.
Financial risk management in personal finance is technically applying risk management principles to individual personal finance.
Four Types of Financial Risk Management Strategies
There are generally four types of financial risk management strategies most people use in personal finance and unknowingly, you’re using one of them in most cases.
- Risk Assumption
- Risk Avoidance
- Risk Sharing
- Risk Transfer
Risk Assumption (Assume Risk)
As mentioned, most people tend to assume their financial risks, simply because they’re not aware of the fact that there are far better way to protect themselves and loved ones’ against serious life events that may affect their financial well-being.
By default, most people assume life’s financial risks on a daily basis, specifically, when it comes to the possibility of loss of or reduced in income.
Risk Avoidance (Avoid Risk)
Another way you can manage risk is by avoiding it.
Say, if you just bought a Tesla Model X, considering the amount of money you would have invested in acquiring this robust kind of a vehicle, you wouldn’t want to risk losing it.
To protect yourself from such a loss, you can avoid driving it completely, park it inside your garage, and just take the bus but then if you come to think of it; that’s going to be counter-productive since the main purpose of acquiring a vehicle is to use it to get from point A to point B, faster then when you’re taking public transport.
Risk Sharing (Share Risk)
Taking the same example we’ve used in the “risk avoidance” risk management strategy, we’ll use your Tesla Model X in the risk sharing strategy. So, instead of parking your car, you decide that it’s going to serve you best if you actually use it, but then, using it in the freeway on a daily basis comes with a high level of risk of actually damaging or losing your vehicle; in this case, you decide that you’re going to share your risk, instead of assuming it on your own or avoiding the risk.
You decide that maybe, it’s a good idea to simply purchase an auto insurance; this way, you can have your cake, and eat it too.
You’re now driving your car to and from your commutes but you have the peace of mind in knowing that should something happens on the road or while it’s parked, somebody else is sharing with you the major portion of the financial loss.
You might be wondering as to why I’m using material possessions as examples of assets in this article; I personally don’t consider vehicles as assets since they depreciate in value over time but using a vehicle, makes these concepts easier to understand for most people.
The best financial risk management strategy is called “risk transfer”. As the name implies, you don’t have to assume, avoid or even share the risk; you can transfer the financial risks altogether.
Of course, this is not applicable in all scenarios but it can effectively protect you and your loved ones against life’s serious events that are beyond your control.
While you may be taking the necessary measures in trying to avoid a serious illness, injury or premature death; these things are sometimes unavoidable as these events are beyond anyone’s control.
Sometimes, life happens!
Transferring your financial risks against things that are beyond your control protects your financial well-being, security and future, in case they happen.
In the previous strategy, I’ve used an expensive car like the Model X as an example but really, when it comes to financial risk management, we’re protecting a far-more valuable asset than any of the material possession that you either dream of or would have already acquired.
We’re protecting your personal “money-making machine”, that if damaged or lost due to a serious life event, will stop producing money for you and/or your loved ones.
The Worst Financial Risk Management Strategy & What You Should Do Instead
Most people assume risks by default, some for lack of knowledge, some think it’s costly to share or transfer their financial risks to financial institutions, some, well, they hope that it won’t happen to them.
Now that you have an idea of what financial risks are and how you can effectively manage your personal financial risks, avoid assuming any type of risk in your financial life, as assuming your risks means assuming the financial hardships or losses that may result from serious life events.
You have to protect yourself and loved ones by implementing a combination of the 3 financial management strategies mentioned in this article.
Avoid. While it’s nearly impossible to avoid the possibility of serious life events affecting you and/or your loved ones, there are things you can do to minimize the probability of these events. Clean and healthy living for example, may help you avoid the risk of a serious illness or premature death.
Share and/or Transfer. These two strategies are your best bet when it comes to protecting your financial security and future. Instead of simply avoiding the risks, you have to implement effective financial risk management strategies that allows you to either share or transfer the financial risks to another entity so you mitigate your potential losses.
We can help you draw up a plan that share and/or transfer your risks to insurance companies by implementing the following plans:
- Health Insurance
- Critical Illness Insurance
- Disability Insurance
- Life Insurance
How Risks Affect Your Personal Finance
Life isn’t perfect and sometimes, things don’t often go as planned and there are life events that may potentially roadblock our financial goals, unfortunately, most life events don’t come with advanced warnings, so, the majority of us fail to plan for them.
Most people don’t plan to fail, they fail to planJohn Beckley
Below are examples of life events that may result to personal financial instability:
- Job Loss and/or Business Setback
- Serious Illness
- Premature Death
Job Loss (and/or Business Setback)
Job loss and business setbacks have similar effects, both scenarios lead to temporary loss of or reduction of income but the effect of such events are usually temporary because if you’re a breadwinner, you will do everything in your power to get back on track with your income, by usually getting another job or doing side-gigs, like driving for Uber (and/or TappCar), delivering food for UberEats or SkipTheDishes or Door Dash, selling stuff or offering any other services that are within your skill set, to survive and make ends meet.
If you migrated from another country, you may now be aware that there’s no such thing as security of tenure in Canada, everyone’s dispensable and you can lose your job or the security of a 9 to 5 income any time.
You may probably qualify for EI or employment insurance but that depends on whether or not your job loss as a result of your own doing; if not, and you have enough EI hours, you’ll receive 55% of your average weekly earnings with a cap of $54,000.00 in annual insurable earnings amount, which means, the maximum you’ll ever receive is $573.00 per week.
Employment insurance is an example of a risk-sharing risk management strategy, so you don’t absorb 100% of the financial impact in case of a job loss, however, while it’s good that EI exists in Canada, the best way to hedge against the financial impact of a job loss or a business setback, is to have an emergency fund in place.
An emergency fund, will help you supplement the shortfall on your EI benefits and hedge from the possibility of not qualifying on such benefit.
Divorce is a sensitive topic but is sometimes completely avoidable if both spouses are willing to work things out, however, the possibility is always there. There are so many impacts that may result from this life event, both emotional and financial, not only to yourself and your spouse but to your kids as well.
While I can’t cover every possible effect that results from a divorce, I would like to zero-in on how you can financially protect yourself from the financial impact.
If you haven’t gone the marriage path yet, consider putting in place a prenuptial agreement, this too is a sensitive topic but by doing so, you are not only protecting yourself financially but your partner as well, should the marriage fail. This puts things into perspective, before you tie the knot.
If you’re already married and was not able to put in place a prenuptial agreement; work things out as much as you can because there should be a reason why you married each other, go back to that “why”, I believe that should be reason enough to stay together.
Of course, I’m not saying that you should stay in an abusive relationship just to avoid financial losses due to a marriage breakdown because if you’re in such a situation, I believe, you’ve already lost a lot.
If things can’t be worked out, here are a few things that you can do to protect yourself financially from a divorce:
As soon as a decision to divorce or a separation has taken place; legally establish the separation in writing and in motion asap. Talk to a lawyer to have this in place because by legally establishing your separation even before the divorce date, you are separating your finances from that of your future ex, which means that any money you earn from the date the separation was established is solely yours.
Also, it’s time to do an accounting of what assets and liabilities you have from that of your spouse.
Separate Joint Accounts
Separate all joint bank and credit card accounts and split your cash and debts accordingly.
If you are jointly responsible for your mortgage, notify your mortgage lender of the coming change.
Establish and Monitor Your Credit
Build your own credit score if you don’t have one established yet; it’s also a good idea to get a credit report and closely monitor your credit until after the proceedings are done for obvious reasons.
Revise Your Will and Power of Attorney
Divorce will not affect nor revoke your Will and Power of Attorney. You have to revise them at once.
Whether you’re working to provide for yourself and loved ones, growing a business, or building wealth for retirement, there are certain risks that may road-block your goals, and these risks may come without notice.
Update Your Insurance and Investments
During such a difficult time, there will be a lot of things that you may take for granted, like changing your insurance and investment beneficiaries. Also check for trading authorizations that you may have granted your spouse.
Talk to your Professionals
There are three professionals that you should work with during this difficult time.
- Your financial advisor
- A lawyer, and
- An accountant.
A financial advisor can help you update your financial policies. Your lawyer and accountant will help you with the proceedings and protect your financial interest for a fair settlement.
The two life events mentioned above are usually uninsurable as they are not pure risks but there are a lot of things that you can do to mitigate or minimize the financial risks to yourself and/or loved ones.
The risk of being inflicted by serious illness is one of the more serious life events that are beyond our control as human beings but this life event is considered a pure risk, which is insurable, meaning, to mitigate or minimize the financial risks of such an event, we can “transfer” this risk to another entity like implementing a critical insurance illness policy.
A serious illness may prevent a person to actively work in a job, business, or profession, which results in loss of or reduced income. This is usually the financial risk that results from such an event. If you transfer this risk to an entity such as an insurance company, the insurance company absorbs the financial risks associated with such an event, instead of you absorbing all the risks.
Similar to serious illness, a disability whether temporary or permanent prevents a person from doing what he or she normally do for a living. The financial risk of a disability is also considered “pure risk”, which is also insurable.
While critical illness insurance pays you a lump sum benefit amount, disability insurance pays you on a monthly basis, replacing up to 80% of your monthly income so you need not worry as to when your next paycheck is coming and instead focus more on getting well.
Transferring the financial risks in case of disability (to an insurance company) is an effective financial risk management strategy the minimizes the financial impact of such an event in case you’re unable to actively work for a living.
A disability may be temporary or may be permanent, we can help you explore the best options that meet your needs.
Death is inevitable, hopefully, it comes at old age but such is one of those serious life events that we don’t have control over. Either we live long or we die young; dying young is premature death and unfortunately, it happens to some people.
While we can’t control as to when we’re going to pass-away, we can manage the financial risks involved in case we pass-away prematurely, so the people who rely on us for financial support can continue living the same quality of life we’re able to provide for them while we’re alive an well.
Life insurance can replace a person financially by replacing the person’s income in case of premature death, pay-off the immediate financial needs in case of such an event, pay-off the deceased’s financial obligations such as consumer debts, mortgage, leave the necessary funds for his or her children’s post-secondary education or even leave a legacy.
Proper life insurance planning minimizes the financial impact of premature death, we can help you implement a well-planned financial risk management strategy that protects your loved ones’ financial security and future against premature death.
The Cost of Risks
What is the cost of risks?
A lot of people gets hung up on the costs of managing their risks, but have you ever thought of the true cost of risks?
The cost of risks differs from person to person, it depends on how much you’re currently worth to yourself and those who depend on you for financial support.
If you’re unable to work today due to a serious illness or prolonged disability, or premature death, would you or your loved ones be able to afford the same quality of life? or would you or your loved ones experience financial hardships?
That is the true cost of risk!
If you have a money-making machine, how much would you pay to replace that machine, or at least the money that it prints on a bi-weekly or monthly basis?
The Objective of Risk Management
The Objective of Risk Management is to minimize or mitigate the financial risks of events that are beyond your control.
As mentioned, there are two types of risks.
One is speculative in nature and therefore avoidable or controllable, so you have the choice of whether or not you should take the risk or applying measures and strategies that minimizes the impact without transferring the risk to someone else.
Pure risk, are risk that occurs due to events that may or may not happen even when we’re not taking an action in search of gains. This type of risk is shareable and transferable.
You implement financial risk management strategies to protect an asset from losses so your financial well-being either stays the same or the impact is minimized in the worst event that you have to assume some of the losses.
Importance of Financial Risk Management
I couldn’t emphasize more the importance of financial risk management in protecting your personal financial well-being. An effective risk management strategy helps you and your loved ones maintain the same or near the same lifestyle should a serious life event ever occur to you or any one of the breadwinners in your household.
Most people don’t give personal financial risk management much thought and tend to assume all the risks themselves, not knowing that they can actually transfer the financial risks to someone else so they don’t have to dip on their assets or retirement funds, should a serious life event affect their ability to actively work for a living.
As financial security advisors, we help our clients plan and maintain their financial security should a serious life event ever affect their ability to make a living for themselves and/or loved ones.
1 thought on “Understanding Personal Financial Risk Management”
It’s vital that you understand how personal financial risk management works because it’s going to help you out with your finances in the future. I am sure you want your finances to do well and you don’t want anything wrong.