Personal Financial Planning - Risk Management

Risk management in financial planning is theA combination of all or several techniques are used
systematic approach to the discovery and treatmenttogether to treat the risk.
of risk. The objective is to minimize worry by dealing(1) Avoidance - The complete elimination of the
with the possible losses before they happen.activity.
The process involves:This is the most powerful technique, but also the
Step 1: Identificationmost difficult and may sometimes be impractical. In
Step 2: Measurementaddition, care must be taken that avoidance of one
Step 3: Methodrisk does not create another.
Step 4: Administration(For example, to avoid the risk associated with flying,
Risk Identificationnever take a flight on the plane.)
The process begins by identifying all potential losses(2) Segregation - Separating the risk.
that can cause serious financial problems.This is a simple technique that involves not putting all
(1) Property Losses - The direct loss that requiresyour eggs in one basket.
replacement or repair and indirect loss that requires(For example, to avoid both parents dying in a car
additional expenses as a result of the loss.crash together, travel in separate vehicles.)
(For example, the damage of the car incurs repair(3) Duplication - Have more than one.
cost and additional expenses to rent another carThis technique requires preparation of additional back
while the car is being repaired.)up(s).
(2) Liability Losses - It arises from the damage of(For example, to avoid the loss of use of a car, have
other' property or personal injury to others.2 or more cars.)
(For example, the damage to public property as a(4) Prevention - Forestall the risk from happening.
result of a car accident.)This technique aims to reduce the frequency of the
(3) Personal Losses - The loss of earning power dueloss occurring.
to death, disability, sickness or unemployment and(For example, to prevent fires, keep matches away
the extra expenses incurred as a result of injury orfrom children.)
illness.(5) Reduction - Minimize the magnitude of loss.
(For example, the loss of employment due to cancerThis technique aims to reduce loss severity and can
and the required treatment cost in addition to normalbe used before, during or after the loss has occurred.
living expenses.)(For example, to reduce losses as a result of a fire,
Risk Measurementinstall smoke detectors, sprinklers and fire
Subsequently, the maximum possible loss (i.e. theextinguishers.)
severity) associated with the event as well as the(6) Retention - Self assumption of risk.
probability of occurrence (i.e. the frequency) isThis technique involves retaining the risk consciously
quantified.or more dangerous as unconsciously to finance one's
(1) Property Risk - The replacement cost necessaryown loss.
to replace or repair the damaged asset is estimated(For example, having 6 months of income in savings
by a comparable asset at the current price. Indirectto protect against the risk of unemployment.)
expenses for alternative arrangements like(7) Transfer - Insurance.
accommodation, food, transport, etc, needs to beThis technique transfers the financial consequences
taken into account.to another party.
(2) Liability Risk - This is considered to be unlimited as(This will be covered in more detail as a topic.)
it will depend upon the severity of the event and theAdministration Of Method
amount the court awards to the aggrieved party.The selected methods must be implemented.
(3) Personal Risk - Estimate the present value of theAnd finally to close the loop for the process, new
required living expenses and additional expenses perrisks must be continually identified and all risks needs
year and computing it over a predetermined numberto be re-measured when required. Treatment
of years at some assumed interest rate and inflation.alternatives should also be reviewed.
Methods Of Treating Risk