The risk management process involves five steps

Risk management is the process of identifying and evaluating situations involving pure risk to determine and implement the appropriate means for its management. The goal is to minimize any risk or potential for risk through advance planning. Risk management entails making the most efficient arrangements before a loss occurs so as to minimize any after-loss effects on your financial status. It is an important part of overall personal financial management, as it preserves the benefits of your other financial planning
efforts. Insurance is merely one of many possible ways of handling risk, and it isnot always the best choice.

The risk-management process involves five steps; Table 10.1 outlines these steps in the risk-management process. 

Step 1: Identify Sources of Risk Sources of risk, called exposures, are the items you own and the activities in which you engage that expose you to potential financial loss. Owning and/or driving an automobile is a common exposure. In riskmanagement, you take an inventory of what you own and what you do in order to identify your exposures to loss.
You face the possibility of loss in one of four ways:

1. . First, you may suffer a loss to your property, such as can happen during a house fire.
2. Second, you could be held legally responsible for losses suffered by others such as if you cause an automobile accident.
3. Third, you may become ill or be injured and have costs associated with health care.
4.  Fourth, you may suffer a loss of income as a result of illness, accident, or death. You also need to identify the perils that you face. A peril is any event that can cause a financial loss. Fire, wind, theft, vehicle collision, illness, and death are all examples of perils.

Step 2: Estimate Risk and Potential Losses Once you identify your exposures to risk, you estimate both loss frequency and loss severity. Loss frequency refers to the likely number of times that a loss might occur over a period of time. Loss severity describes the potential magnitude of the loss(es). Many people wonder whether they should buy insurance when loss frequency is low, for example if they are young and healthy or if they live in a safe neighborhood. This is not a good way to think about potential losses. If loss frequency is low, the insurance would simply cost less. Figure 10.1 illustrates the relationship between loss severity and loss frequency in risk management. What is more important is loss severity. “How much might I lose?” is the question you should ask. When considering possible property losses, you simply make an estiperil  mate of the value of the property. Liability losses are more complicated because the severity of the loss depends on the circumstances of the person you harm. For example, if you caused an accident that permanently disabled a young heart surgeon with three small children, you would be liable for the surgeon’s care, lost earnings over the surgeon’s lifetime, and future care and education of the children. A loss of several million dollars is not out of the question in such a situation.

Step 3: Choose How to Handle Risk The risk of loss may be handled in five ways: risk avoidance, risk retention, loss control, risk transfer, and risk reduction. Each strategy may be appropriate for certain circumstances, and the mix that you choose will depend on the source of the risk, the size of the potential loss, your personal feelings about risk, and the financial resources you have available to pay for losses.

•  Risk avoidance. The simplest way to handle risk is to avoid it. With this approach, you would refrain from owning items or engaging in activities that expose you to possible financial loss. For example, choosing not to own an airplane or not to skydive limits your exposure. Avoiding risk is not always practical, however.
• Risk retention. A second way to handle risk is to retain or accept it. The risk that the shrubbery around your house might die during a dry spell is such a retained risk. Conscious risk retention plays an important role in risk management. Risk retention due to ignorance or inaction is not effective risk management. For example, many people unwisely put off the purchase of life insurance because they consider it to be a morbid, unpleasant task.
•  Loss control. Loss control, the third method of handling risk, is designed to reduce loss frequency and loss severity. For example, installing heavy-duty locks and doors will reduce the frequency of theft losses. Installing fire alarms and smoke detectors cannot prevent fires but will reduce the severity of losses from them. Insurance companies often require loss-control efforts or give discounts to policyholders who implement them.
• Risk transfer. A fourth way to handle risk is to transfer it. In a risk transfer, an insurance company agrees to reimburse you for a financial loss. For example, a professional football team’s star run

• ning back might take out an insurance policy on his legs. In this case, the uncertainty is simply transferred from the running back or his team to an insurance company. Insurance represents one method of transferring risk, although not all risk transfers can be classified as insurance because insurance goes beyond merely transferring risk to the actual reduction of risk.

• Risk reduction. The fifth way to handle risk is to reduce it to acceptable levels. Insurance is used by policyholders when they arrange for all or a portion of their risk to be covered by an insurance company, thereby reducing their personal level of risk.

Step 4: Implement the Risk-Management Program The fourth step
in risk management is to implement the risk-handling methods you have chosen. For most households, this means buying insurance to transfer and reduce risk. This involves selecting types of policies and coverage, dollar amounts of coverage, and sources of insurance protection. People often wonder what types of insurance to buy and how many dollars of coverage to choose. You should use the maximum possible loss as a guide for the dollar amount of coverage to buy. This way of thinking makes use of the large-loss principle: Insure the losses that you cannot afford and assume the losses that you can reasonably afford. In other words, pay for small losses out of your own pocket and purchase as much insurance as necessary to cover large, catastrophic losses that will ruin you financially. The example earlier of an auto accident that injures a heart surgeon would bring you such ruin because you would be held responsible for those losses. Consequently, you would want high dollar amounts of liability coverage on your auto insurance.

Step 5: Evaluate and Adjust the Program The final
step in risk management entails periodic review of your riskmanagement efforts. The risks people face in their lives change continually. Therefore, no risk-management plan should be put in place and then ignored for long periods of time. For certain exposures, such as ownership of an automobile, an annual review is appropriate. For areas involving life insurance, a review should occur about once every three to five years or whenever family structure and employment situations change. The necessary adjustments should be implemented promptly to reflect changes over your life cycle. Many people stick with existing policies that no longer fit their needs (too little or too much coverage) simply because they buy once andignore their insurance needs for years.

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