Risk management and insurance

The four responses to risk

Any identified risk can be handled in one of four ways, and the discipline of naming which one you are choosing prevents both under- and over-insuring.

• Avoid. Do not take the risk at all. Effective where possible, but most worthwhile activities carry risk.
• Reduce. Lower the probability or the severity. Smoke alarms, health measures, diversification, safety equipment.
• Transfer. Pay somebody else to carry the financial consequence. This is what insurance is, and also what some contracts and business structures accomplish.
• Retain. Accept it and absorb the cost yourself. Every deductible is retained risk, as is everything you have chosen not to insure.

The right response depends on two variables: how likely the event is, and how severe it would be. Severity matters more. A frequent but trivial loss can be absorbed; a rare but ruinous one cannot, which is precisely why it should be transferred.

Identifying exposures

Before considering any product, list what could actually go wrong. A workable prompt list for a household:

• Loss of income — death, disability, serious illness, redundancy, business failure
• Loss of property — fire, theft, storm, flood, earthquake, vehicle
• Liability — injury to others, property damage, professional exposure, being a landlord or employer
• Health costs — treatment, ongoing conditions, extended care
• Longevity — outliving resources
• Concentration — employer stock, a single business, one property

For each, ask three questions: how likely is it, what would it cost financially, and could the household absorb that cost without abandoning its objectives? The exposures that fail the third test are the ones that need action.

The core insurance principle

Insurance is most valuable where losses are unlikely but potentially devastating. That is the arithmetic of the business: the insurer pools many premiums to pay the few large claims that occur.

Two implications follow. First, insuring small, affordable losses is usually poor value — you pay the insurer's costs and margin for the privilege of not absorbing something you could easily absorb. Extended warranties on inexpensive goods are the standard example. Second, raising a deductible on a policy you keep for genuinely large losses generally lowers premiums while retaining the protection that matters. You are choosing to retain the small losses and transfer the large ones, which is exactly right.

The main personal lines

Life insurance

Life insurance exists to replace the economic contribution of someone whose loss would leave others financially exposed. The first question is therefore not how much, but whether anyone actually depends on you financially. If nobody does, cover may serve other purposes — estate liquidity, business continuity, a specific bequest — but the core justification is absent.

Term insurance covers a fixed period with no investment element. It is straightforward and, for a given amount of cover, generally the least expensive way to buy protection. It suits the common shape of the need: large while children are dependent and a mortgage is outstanding, smaller or unnecessary later.

Permanent insurance — whole life, universal life and variants — is designed to last for life and typically accumulates a cash value. It is more expensive and considerably more complex, with charges and crediting mechanisms that are not always transparent. It has legitimate uses in specific circumstances, particularly estate liquidity and certain business arrangements. It is also, industry-wide, among the most heavily commissioned products sold to retail buyers, which is a fact worth holding in mind when it is recommended. If a permanent policy is proposed to you, ask for the full illustration including guaranteed columns, ask what the total charges are, and ask what the recommendation would look like if the adviser were paid a flat fee instead.

Disability insurance

During working years, the probability of a disability lasting long enough to interrupt income is meaningful, and for most working people their earning capacity is their largest asset by a wide margin. Yet disability cover is insured far less consistently than life cover.

The details matter more here than in almost any other line:

• Definition of disability. "Own occupation" pays if you cannot perform your specific job; "any occupation" pays only if you cannot perform any job you are reasonably suited to. The difference is enormous.
• Elimination period. How long before benefits begin, and whether reserves can bridge it.
• Benefit period. A few years, or through to retirement age.
• Taxation. Whether benefits arrive taxable or tax-free generally depends on who paid the premiums.
• Group vs. individual. Employer cover is convenient but usually ends with the job and may be capped in ways that under-serve higher earners.

Liability and umbrella cover

Liability is the exposure most often under-insured relative to its potential severity, because the underlying limits on home and auto policies are frequently set at defaults that bear no relation to what a serious claim could cost — or to the assets that would be exposed.

An umbrella policy provides additional liability cover above those underlying limits and is generally inexpensive relative to the protection it adds, because large claims are rare. Situations that raise exposure include teenage drivers, swimming pools, rental property, dogs, hosting events, serving on boards, and having assets visible enough to make a claim worth pursuing.

Emergency reserves

Cash reserves are self-insurance and belong in this discussion. They cover the risks too small, too frequent or too uninsurable to transfer — a boiler, a car repair, a gap between jobs — and they prevent the far more damaging response of selling investments at a bad moment or borrowing at high rates.

How much is genuinely personal. Stable dual incomes with secure employment need less; variable income, self-employment, single-income households and specialised careers with long job searches need more. The reserve should be held somewhere accessible and stable, which means accepting that it will not keep pace with inflation. That is the price of liquidity, and it is worth paying for the portion you might actually need.

Reviewing cover

Insurance needs move with life events, usually upward for a period and then downward. Review after marriage or divorce, a birth, a home purchase, a significant income change, starting a business, and a change of employer — group cover rarely follows you. Review downward too: cover bought for a need that has passed is money spent for nothing.

And read the exclusions. A policy is defined as much by what it does not cover as by what it does, and claim disputes almost always turn on a definition or an exclusion rather than on whether something bad happened.