RPF0091-Do_I_Need

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00:00:29.600 | How would you know if you needed to buy insurance or not?

00:00:33.000 | Today I'm going to try to give you a framework to answer that question.

00:00:35.700 | Not talking about a specific type of insurance or selling you any kind of insurance,

00:00:40.000 | but rather trying to give you a mental framework to use to consider the risks that you face in your life

00:00:46.700 | and the appropriate way to handle them.

00:00:49.400 | I think it's going to be good.

00:00:50.600 | [Music]

00:01:07.000 | Welcome to the Radical Personal Finance Podcast.

00:01:09.500 | My name is Joshua Sheets and I'm your host.

00:01:11.500 | Today is Wednesday, October 29, 2014,

00:01:15.700 | and today we are going to continue with our Financial Planning Education Series by talking about risk.

00:01:22.900 | And we are going to talk about various methods of risk control, risk financing, risk avoidance, etc.

00:01:31.000 | Today is Episode 91.

00:01:34.000 | I hope you enjoy.

00:01:35.000 | [Music]

00:01:39.000 | I'm often asked the question, "Joshua, how would I know if I needed to buy insurance or not?"

00:01:43.300 | Or maybe you are considering a specific type of insurance and you're trying to figure out,

00:01:48.200 | "How would I think through my decisions that are associated with this insurance policy?"

00:01:52.300 | This is simply not an easy answer.

00:01:53.900 | So the way that we usually buy insurance in our society is when we are face-to-face with an insurance agent.

00:01:59.800 | I've been an insurance agent for a long time and usually, many times,

00:02:03.400 | the first time that somebody has thought about buying an insurance policy on something

00:02:06.900 | is when I'm sitting there presenting a policy to them or diagnosing a need in their life and saying,

00:02:12.800 | "Hey, here's the need. You should buy an insurance policy for this.

00:02:15.500 | I've researched your situation. I've understood the different things that you're facing.

00:02:20.000 | And so I think that you should buy this insurance policy."

00:02:22.800 | And assuming that the insurance agent is excellent at their craft and is knowledgeable and skillful

00:02:28.800 | and they've accurately diagnosed your need, I think that works fine in a majority of cases.

00:02:33.000 | But many times, you get the question from people and they'll often sit back and ask,

00:02:37.900 | "How would I know if I need to buy insurance?"

00:02:41.700 | You'll often hear the term, "Well, what if I'm self-insured?"

00:02:45.400 | Well, how would you know if you're self-insured?

00:02:48.600 | And usually, people make this sound like it's a simple, straightforward answer,

00:02:52.300 | but there are many types of insurance. There are many types of risks.

00:02:55.500 | And self-insurance is often not actually a simple thing to figure out.

00:03:02.400 | So today, I'm going to try to give you a framework to hold in your mind

00:03:07.200 | that will help you to make better decisions about how to handle the risks that you face in your life.

00:03:13.800 | And I'm actually not going to be talking about insurance.

00:03:16.800 | Where I anticipate ending today's show is with insurance as an option,

00:03:20.200 | but I'm going to talk about all of the other ways to handle risk that don't involve insurance.

00:03:25.400 | And as I mentioned in the intro, I'm not talking about any one specific type of insurance.

00:03:29.500 | I'm not talking about life insurance or errors and omissions insurance or any of these types of insurance.

00:03:34.700 | I'm just talking about insurance as a general concept.

00:03:37.400 | So this is the type of information that you would be presented if you were taking an insurance class in college.

00:03:43.100 | This is an academic framework.

00:03:45.200 | But we're not going to stay in academic theory that sometimes can be useless.

00:03:51.000 | This is very, very useful.

00:03:52.900 | And I think it's going to give you some understanding that unless you have a background in risk

00:03:57.800 | or in a background in insurance studies,

00:04:00.400 | I think this will give you an understanding that you can apply to your daily life

00:04:03.300 | and you can apply to everything from how big should my emergency fund be

00:04:07.200 | to should I buy this extended warranty on this new television that I'm buying

00:04:12.500 | to should I buy life insurance for my family's protection

00:04:15.900 | to should I buy insurance on my $300 million worth of cargo that I'm putting onto a cargo ship.

00:04:22.600 | This is applicable to every one of those decisions.

00:04:26.900 | It's very important that we continually talk about risk management.

00:04:30.500 | When it comes to financial planning, risk management is key.

00:04:33.400 | One of the most important aspects of good financial planning is to basically avoid being wiped out.

00:04:41.300 | If you've accumulated money or assets of some kind that aren't specifically related to money,

00:04:48.100 | you need to avoid being wiped out because those assets, that money represents your principle.

00:04:53.900 | And as we all know about the compound growth that can come with growth of interest

00:04:58.800 | or just basically growing assets, you need principle covered in order to grow assets.

00:05:04.700 | Now at the beginning if you're young and you're just getting started,

00:05:07.100 | this may not seem very valuable to you, but you still have major assets.

00:05:11.300 | Your major assets might be your human capital, your physical energy, your vitality, your ability to work.

00:05:16.900 | If you want to start valuing that, start working with somebody who doesn't have that ability.

00:05:21.000 | And man is it tough when you don't have the ability to go out and get a job.

00:05:23.800 | So you need to protect that.

00:05:25.500 | We all have a certain amount of human capital and that needs to be protected.

00:05:28.900 | Now you may transition over time as you build wealth to where your human capital is actually far less valuable

00:05:35.100 | from a monetary sense than your financial capital.

00:05:39.900 | If you're running several multi-million dollar businesses and you have,

00:05:43.800 | maybe you have hundreds of millions of dollars of revenue and you have dozens or hundreds of employees working for you,

00:05:49.000 | then your personal ability to do a certain task, to swing a hammer, is not going to be as important as that the business is

00:05:58.100 | in terms from a financial perspective.

00:06:00.100 | So that would change and it would become less important for us to necessarily worry about

00:06:04.600 | physically protecting your ability to swing the hammer and much more about protecting the business.

00:06:09.500 | But these concepts are the same all the way through.

00:06:11.600 | So I'm going to challenge you, you need to consider in order to be wealthy and to stay wealthy,

00:06:16.200 | you always, always, always need to be carefully considering risk management.

00:06:21.000 | And you want to recognize that the risks as you go through life are going to change.

00:06:25.300 | They are very different as you go through life, but there are still risks that you have to deal with.

00:06:31.200 | This is so important. I consider myself to be the chief risk officer of my family.

00:06:35.400 | So if you have a family, if you're in a family, if you are the head of a family, this should be your job as well.

00:06:41.800 | You're the chief risk officer for your family.

00:06:44.200 | If I'm watching my child play on a play set, I need to be very careful about the risks.

00:06:50.600 | It is my job to protect my child from the risks that they are facing.

00:06:54.900 | Now, I need to do that with carefulness.

00:06:57.500 | I need to not be overly protective or underly protective.

00:07:01.200 | I need to be properly protective.

00:07:02.900 | And there are certain risks which we would consider acceptable.

00:07:06.600 | I would consider acceptable.

00:07:09.400 | They're usually risks with maybe a low potential severity of loss.

00:07:13.200 | And then there are risks that I would consider not to be acceptable.

00:07:16.800 | And you can fill in plenty of examples.

00:07:19.600 | You may be the chief risk officer of a business.

00:07:22.000 | If you own a business, if you are an entrepreneur, you are the chief risk officer of your business.

00:07:26.800 | If it's a very large company, you could even have a formal title of a chief risk officer.

00:07:33.000 | For years, I've subscribed to a magazine.

00:07:34.600 | It's one of these free ones when you're in the business world.

00:07:36.200 | They send you, people send you all these free magazines.

00:07:38.200 | There's one called Risk and Insurance.

00:07:41.000 | And it comes in. It's this huge like newspaper format.

00:07:44.000 | And the thing I always enjoyed reading about it was reading about all these wacky kinds of insurance that I never knew existed.

00:07:50.400 | And this seems to be a magazine that's written for people who are chief risk officers of companies.

00:07:55.300 | But it's, you know, the idea is how do you properly manage your risk if you're sending off a billion dollars worth of cargo on a freighter and there's nuclear material that you're transporting?

00:08:06.000 | How do you manage that risk?

00:08:07.900 | Or I mean it's just these wild, crazy scenarios that I've never even considered.

00:08:13.500 | And it's so fascinating to me to see how the same concept that I would use in day-to-day financial planning would be – is applicable to this multimillion dollar business.

00:08:22.700 | So I hope you find the content valuable.

00:08:25.200 | I wanted to kind of lay that out as far as being why I am setting this up for you.

00:08:31.000 | So let's get into some terms and I'm going to avoid most of the boring stuff that you would learn in the first week of a risk class, a college – risk planning class or a college insurance class.

00:08:41.300 | I'm going to avoid most of the boring stuff.

00:08:43.000 | But it is important to define a few terms.

00:08:45.300 | And if you've ever gone through an insurance licensing program, usually property and casualty, this is a big deal.

00:08:50.500 | They'll go through and they'll define for you certain terms.

00:08:53.200 | And these would be terms such as risk, such as loss, such as hazard, such as peril.

00:08:58.700 | I'm going to avoid most of the stuff that doesn't matter.

00:09:01.000 | But you do need to understand a couple of definitions as we get into ways to manage risk.

00:09:06.200 | And we're actually going to start with the word risk.

00:09:08.400 | Now, depending on the context – and again, this episode today is focused on – I'm considering myself to be speaking to prudent individuals who are interested in financial planning.

00:09:20.200 | So the word risk would be defined differently if you were running an insurance company than if you were just an individual.

00:09:26.000 | But for the definition of today, I'm just going to simply call risk as the possibility of loss.

00:09:31.300 | Anytime that you consider yourself to have a possibility of loss – and a loss usually would be defined as some sort of decline in value.

00:09:38.800 | And usually we would consider this to be maybe in some kind of unexpected or unpredictable way.

00:09:45.800 | So as an example, I'm referring to the possibility of loss primarily over having a car accident rather than the relatively expected loss and decline in value because of depreciation on the car,

00:10:02.600 | of the car becoming used up and then having its value in the marketplace decreased, which we would call depreciation.

00:10:09.600 | And there are tons and tons of different types of risks and different types of loss that we would face.

00:10:15.600 | And so in the technical insurance world, we would use a word called loss exposure.

00:10:20.600 | What is your specific loss exposure if certain things were to happen?

00:10:25.600 | So if your house were to burn down, what is your loss exposure?

00:10:28.600 | How much is it?

00:10:30.600 | There are different types of losses.

00:10:31.600 | There are direct losses and indirect losses.

00:10:34.600 | So for example, in my house example, the direct loss would be what is the immediate loss that happens when an event happens?

00:10:41.600 | Or an indirect loss would be kind of any secondary happening.

00:10:46.600 | So a direct loss, let's say that a tornado comes through.

00:10:49.600 | Or let's stick with the fire example.

00:10:51.600 | So let's say that a fire comes into your house and that fire causes a specific damage to your house.

00:10:57.600 | But then you have the secondary indirect loss of you can't live in your house so you have to go and stay in a hotel.

00:11:04.600 | How do you cover those expenses?

00:11:07.600 | So there's all kinds of different definitions around these words.

00:11:11.600 | It's important to understand the words peril and hazard.

00:11:14.600 | You will read these words in your insurance contract, specifically in your property and casualty contracts.

00:11:20.600 | Peril in insurance definitions, peril refers to the specific cause of a loss.

00:11:26.600 | So there are many types of perils.

00:11:29.600 | So a peril would be things like unemployment, illness, old age, theft, fire, earthquake, windstorm, flood.

00:11:39.600 | There are plenty of perils, but the peril is the specific cause of a loss.

00:11:44.600 | Now hazard is actually any kind of act or condition that increases the likelihood of the occurrence of a loss.

00:11:52.600 | And/or increases the severity of a loss if a peril does occur.

00:11:57.600 | So there are many different hazards that can happen and hazards can be adjusted.

00:12:03.600 | Usually insurance textbooks will talk about three different major categories of hazards.

00:12:08.600 | So there would be physical hazards, moral hazards, and attitudinal hazards.

00:12:12.600 | So physical hazards would be physical conditions relating to location, structure, occupancy, exposure, and the like.

00:12:19.600 | So if your house is physically located closer to the ocean where I live in Florida versus farther away, there is a higher hazard there.

00:12:29.600 | Maybe you have high blood pressure, so that's a hazard, that's a condition that is increasing the likelihood of a certain medical event.

00:12:38.600 | Maybe you have some kind of dangerous hobby.

00:12:40.600 | Maybe you are using a chainsaw and you have a dangerous type of employment like that.

00:12:45.600 | Maybe there is just simply, you know, you have a big pile of gas cans and gassy rags stored in the corner of your garage.

00:12:54.600 | Maybe you just have a house that's poorly built.

00:12:57.600 | Maybe you have some sort of problem in the car.

00:13:01.600 | Or maybe that your property is poorly designed and you don't have a good drainage system.

00:13:07.600 | So these are all conditions that increase the chance of a loss if there is a specific peril that were to happen.

00:13:15.600 | The moral hazards would be things like dishonest tendencies.

00:13:19.600 | So let's say that you hire a worker for your business and this worker is in a tough financial spot.

00:13:26.600 | Well, that's a moral hazard there where you have a worker that has a higher than normal incentive to steal from your business.

00:13:34.600 | And this would be a real problem.

00:13:37.600 | Another example would be something like the subprime mortgage crisis.

00:13:42.600 | So in a situation where the housing prices were decreasing and interest rates were increasing,

00:13:50.600 | then there was an additional moral hazard of people just simply choosing to do something like burn their house down.

00:13:58.600 | So that was creating conditions that were increasing the risk of loss.

00:14:03.600 | Then the final one would be attitudinal hazards.

00:14:05.600 | So this would be carelessness or indifference as to whether a loss occurs or the size of a loss if it does occur.

00:14:11.600 | So this would be something you would see in our own individual lives.

00:14:15.600 | Perhaps I'm lazy.

00:14:17.600 | Perhaps I'm disorderly.

00:14:19.600 | Perhaps I don't care for my teeth.

00:14:21.600 | Perhaps I just simply don't care about other people.

00:14:24.600 | I leave my car doors unlocked.

00:14:26.600 | I smoke cigarettes every day and I know that that's going to increase my health risk.

00:14:30.600 | So certain people would have a higher level of attitudinal hazard that that would impact.

00:14:38.600 | So just by starting with some of those basic insurance definition terms,

00:14:42.600 | then you would actually be able to figure out how to start controlling your risk, which is where we're going.

00:14:47.600 | If you had the choice between hiring two candidates for your firm that were equally well qualified,

00:14:52.600 | but you're in a firm where, let's say, that you have inventory control problems

00:14:58.600 | and it's common or likely or easy for people to steal from you,

00:15:03.600 | if you had two candidates that were easily hired, excuse me, that were both equally qualified

00:15:09.600 | and one of those candidates was in a poor, weakened financial condition,

00:15:13.600 | that would be exposing yourself to an additional hazard if you were to choose to hire that one

00:15:17.600 | versus the one who was in a strong financial condition.

00:15:20.600 | Now, obviously, maybe your decision would go the other way,

00:15:24.600 | and you would say, "I'm going to choose to hire the person who's in a weakened financial condition

00:15:29.600 | so that I can help them with a source of income."

00:15:32.600 | But you need to be aware of the fact that you're opening yourself up to an increasing hazard,

00:15:37.600 | and that's the key point.

00:15:39.600 | You may choose to continue with these hazards, but you need to be aware of them.

00:15:44.600 | Insurance companies and academics have also come up with various ways of classifying risks.

00:15:48.600 | So there would be various classifications, but they may be things such as

00:15:53.600 | financial risks versus non-financial risks, particular risks versus fundamental risks,

00:16:00.600 | static risks versus dynamic risks, pure risks versus speculative risks,

00:16:05.600 | and insurable risks versus uninsurable risks.

00:16:08.600 | And I want to walk through these briefly, and don't get worried about us being kind of two-way down in the academics.

00:16:14.600 | I just want to demonstrate to you a few of the concepts that have been developed around this subject

00:16:19.600 | so that you can apply just a thought process to your own situation.

00:16:25.600 | So financial risks versus non-financial risks.

00:16:28.600 | Some risks would be financial risks in the sense that there's a potential loss of money,

00:16:34.600 | or there may be a non-financial risk.

00:16:36.600 | So maybe you are having a non-financial risk that maybe you have a stroke.

00:16:42.600 | Then you have additional pain and suffering and paralysis and a loss of memory.

00:16:47.600 | That would be a problem.

00:16:49.600 | So there would be non-financial risks associating from the stroke,

00:16:53.600 | but then there would also be the financial risks, such as medical bills and lost earnings.

00:16:57.600 | So there may be two kinds of risk, even with the same event,

00:17:01.600 | but we're primarily with insurance going to be dealing with financial risks.

00:17:05.600 | So insurance is generally not going to compensate the victim of a stroke for their pain and suffering.

00:17:11.600 | Insurance is generally going to be focusing on compensating them for the monetary loss,

00:17:15.600 | the monetary loss of their medical bills and the monetary loss of their loss of work and lost income.

00:17:24.600 | So there might be some crossover here for a non-monetary loss,

00:17:29.600 | but usually it's going to be focusing on a financial loss.

00:17:33.600 | With regard to a classification of particular risks versus fundamental risks,

00:17:41.600 | particular risks would be possibilities of loss that only affect specific individuals

00:17:49.600 | or maybe small groups of individuals instead of society at large.

00:17:53.600 | So perhaps you have an event such as an employee embezzles money from you

00:18:00.600 | or you have a medical condition that causes you to be disabled, something like that.

00:18:05.600 | It's specifically affecting you as an individual or as a family or as a business.

00:18:11.600 | Maybe you have a house fire. That's a particular risk in your specific situation.

00:18:15.600 | Fundamental risks, however, this would be possibilities of loss

00:18:19.600 | that would affect a much larger segment of society at the same time.

00:18:23.600 | Maybe this is regional or citywide, something like that.

00:18:26.600 | So if you had an economic downturn that created widespread unemployment

00:18:31.600 | or maybe there was a high amount of inflation in the monetary supply

00:18:36.600 | and so therefore your money loses purchasing power

00:18:39.600 | or there's a nuclear accident at a local nuclear reactor and this affects an entire region

00:18:46.600 | or maybe you had some kind of widespread pandemic like Ebola, something like that.

00:18:53.600 | Ebola is not a widespread pandemic in the U.S., but it certainly is in Africa.

00:18:59.600 | I'm not sure if it would be qualified as a pandemic.

00:19:01.600 | It's a widespread sickness.

00:19:03.600 | So particular risks are usually considered to be the responsibility of the individual.

00:19:09.600 | You as an individual are considered to be responsible to protect yourself from the risk of unemployment

00:19:15.600 | or you as a business owner, you need to protect yourself from the risk of a fire in your place of business.

00:19:21.600 | Fundamental risks usually in our society are tried to deal with them on a society-wide issue

00:19:28.600 | and this is where the government steps in as primarily responsible for fundamental risks.

00:19:33.600 | Now that seems to break down sometimes in my opinion when you look at various government programs

00:19:38.600 | and that's where you get into the challenge of different political parties and political schools of thought

00:19:44.600 | trying to argue about should we cover some of these risks.

00:19:47.600 | This is just more of a mental classification.

00:19:50.600 | You would also have a classification of static risks versus dynamic risks.

00:19:55.600 | So static risks are risks that exist apart from any changes in society or the economy.

00:20:03.600 | This would be risks such as death or again your house burns down specific to you.

00:20:09.600 | Dynamic risks, however, would be a possibility of loss that results directly from a change in society or in the economy.

00:20:16.600 | So maybe there's a change in consumer taste and preference.

00:20:19.600 | This would cause loss to certain types of businesses.

00:20:23.600 | Maybe there's a change in technology that causes loss to some businesses that don't adapt to technology.

00:20:31.600 | A good example here would be something like film photography versus digital photography

00:20:36.600 | or perhaps even a better example would be the destruction of the market for things like the flip camera.

00:20:42.600 | I don't know if you remember that, the flip video camera and these little handheld video cameras.

00:20:46.600 | The destruction by the invention of the cell phone camera or the real deterioration of the market for handheld vehicle,

00:20:55.600 | standalone GPS units because of GPS becoming a standard feature in a cell phone.

00:21:01.600 | So this would be a good classification just to consider what are the different risks that would face you.

00:21:12.600 | Static risks are usually fairly predictable so you can cover them with insurance.

00:21:17.600 | Dynamic risks are less predictable and they're probably not going to be so easily covered with an insurance solution.

00:21:25.600 | Then you have pure risks versus speculative risks.

00:21:28.600 | This is one of the most important topics for insurance because pure risks involve only the chance of loss or no loss.

00:21:37.600 | So either you do lose or you do not lose.

00:21:40.600 | Whereas a speculative risk may have a loss, no loss and no gain or a gain.

00:21:47.600 | So the pure risk is pure in that it doesn't mix profit and losses.

00:21:52.600 | This is where insurance is primarily going to deal specifically with loss, problems created by pure risk, loss.

00:22:01.600 | However, speculative risk would possibly involve gain.

00:22:06.600 | And so gambling would be a good example of a speculative risk.

00:22:11.600 | If you are gambling, whether that's on some sort of gambling game, you have the risk of loss.

00:22:17.600 | You have the risk of – also the risk of – or the potential for gain.

00:22:22.600 | So you're not going to cover a speculative risk generally with insurance.

00:22:28.600 | Insurance just simply is going to transfer a pure risk, a risk that already exists.

00:22:33.600 | And then there are different types of this.

00:22:36.600 | So you would have personal risks.

00:22:37.600 | So this would be risks to you.

00:22:39.600 | Different types of pure risks.

00:22:40.600 | Excuse me.

00:22:41.600 | Different types of pure risks.

00:22:42.600 | So personal risks would be risks to you of death, injury, illness, old age, unemployment.

00:22:47.600 | You would also have property risks.

00:22:49.600 | So you would face pure risks of property, maybe that your car could be damaged in an accident.

00:22:54.600 | Maybe you had a loss from fire, lightning, hurricane, flood, other force of nature.

00:23:00.600 | Or maybe you had theft, vandalism, an accident, collision accident, terrorist activity, things like that, that would occur to you as property risk.

00:23:08.600 | And then liability risk would be a risk that you're exposed to due to your actions.

00:23:16.600 | So maybe you become – you have an accident and you become legally liable for the injury to the other person in the accident or to the damage of the other person's property.

00:23:24.600 | So this would be – you may have legal responsibility for your actions.

00:23:28.600 | This would be liability risks.

00:23:30.600 | So there are certain types of risks that are insurable and there are certain types of risks that are uninsurable.

00:23:36.600 | And we're going to move to different ways of handling risk.

00:23:39.600 | But the only types of insurable risks – and this is, again, basic to any risk textbook in a college level – is that all insurable risks are usually financial, particular, static, and pure.

00:23:57.600 | Financial, particular, static, and pure.

00:24:00.600 | So the amount of the loss must be important.

00:24:04.600 | Generally, you're only going to insure something where the actual amount of loss is going to matter.

00:24:10.600 | You're not going to insure the loss of a stick of gum out of your pocket.

00:24:13.600 | That's not a big deal.

00:24:15.600 | But you're going to insure the loss of your car by theft.

00:24:19.600 | The loss must be of an accidental nature.

00:24:22.600 | So there has to be something that happens due to accident, not due to willful action.

00:24:28.600 | The potential future loss must be able to be calculated, must be able to be calculated in advance in order to be insured.

00:24:35.600 | The loss must be definite, whereas it has a clear definition of how much it is.

00:24:44.600 | And it must be – it cannot be excessively catastrophic because you can't have a loss where it's going to expose the insurance company to a particular risk that could destabilize the insurance company.

00:24:57.600 | A simple example, an insurance company will generally never accept something like $2 billion of life insurance on somebody's life because that would – if that one person were to die too early, that would expose the insurance company to an unacceptable amount of loss.

00:25:15.600 | Now, different people handle risk differently depending on their individual makeup.

00:25:20.600 | That's up to you to decide about how to handle it.

00:25:23.600 | But there are different methods of working with risk.

00:25:26.600 | And this is the primary focus of the mental framework that you can use to figure out what you should do in your situation.

00:25:35.600 | The fact is that risk exists.

00:25:38.600 | And I'm not aware of any method that you would be able to eliminate all risk from your life.

00:25:43.600 | It's just simply not possible.

00:25:46.600 | But you will choose to deal with many of the risks in different ways.

00:25:49.600 | And there's two basic methods of treating risks.

00:25:52.600 | First, you have risk control.

00:25:55.600 | And then you have risk financing.

00:25:58.600 | Risk control is essentially techniques that are designed to minimize the frequency and severity of losses.

00:26:08.600 | Whereas risk financing is about techniques that are used to pay for any losses that do occur.

00:26:15.600 | And there are different types and methods of each of these.

00:26:18.600 | So let's start with risk control.

00:26:19.600 | So, again, risk control, we're trying to minimize the frequency and severity of losses.

00:26:26.600 | The first risk control method would be risk avoidance.

00:26:29.600 | And this is the most -- probably the most, in some ways, effective but also the most extreme form of risk control.

00:26:37.600 | And this would be where you would simply decide not to have any exposure to a loss.

00:26:43.600 | Or you would choose to eliminate an exposure to a loss that already exists.

00:26:49.600 | So an example here would be you would choose not to put a trampoline in your backyard in order to avoid the loss of liability

00:26:58.600 | if the neighbor kids were to come over and jump on your trampoline, fall off, and break their neck.

00:27:02.600 | Or if there were a trampoline that were already there, you would take it out.

00:27:06.600 | Maybe you would choose that instead of buying a home where you would then be exposed to the risk of loss in case of fire

00:27:13.600 | and the loss of the value of the house, you would just simply choose to rent where you would not need to worry about the loss of the house.

00:27:21.600 | If the house burns down, that's not your fault -- or excuse me, it's not your responsibility.

00:27:25.600 | You didn't actually lose -- other than your possessions, you didn't lose the value of the house.

00:27:29.600 | Maybe you would have an example in business where in business you would choose to make or not make a certain product that would maybe expose you to liability.

00:27:41.600 | Some companies, for example, maybe you wouldn't make a certain type of chemical.

00:27:45.600 | Maybe you wouldn't make a certain type of weapon.

00:27:49.600 | Maybe you wouldn't manufacture a certain type of automobile that would expose you to any potential liability claims.

00:27:56.600 | If you are concerned about risk from an airplane accident, you would choose not to fly in an airplane or maybe not to choose not to have your own airplane.

00:28:08.600 | If you're concerned about getting a sport injury, tearing your ACL, then you might choose not to play football or soccer where you would have the possibility of tearing your ACL.

00:28:18.600 | So this would be risk avoidance.

00:28:20.600 | It's practical in some areas.

00:28:23.600 | If you don't ever ride on a motorcycle, you're avoiding the risk of being killed in a motorcycle accident.

00:28:28.600 | But it's not necessarily a practical solution in many other areas.

00:28:33.600 | So if you are not riding on a motorcycle, it's tough in most of our societies to avoid riding in an automobile.

00:28:40.600 | So now you're exposed to the risk of automobile.

00:28:43.600 | Is it possible to avoid that risk? Sure.

00:28:45.600 | But a lot of times, even as a good example, is that you may avoid one risk and then that would create another.

00:28:51.600 | So if you avoid traveling in a private automobile by moving to a large city with public infrastructure and public transportation, so now you're riding a bus or you're riding the subway, then now you're exposed to the risk of a subway crash or falling off the platform onto the tracks.

00:29:06.600 | So you're exchanging one risk for another.

00:29:09.600 | So if the risk is unavoidable, then you've got to consider some other solution other than risk avoidance.

00:29:18.600 | So the second method of controlling the risk would be loss prevention.

00:29:25.600 | And the second and third methods, the second is loss prevention and the third is loss reduction, these are pretty closely related.

00:29:32.600 | Loss prevention would refer to a risk control measure that's intended to lower the probability of loss or the frequency with which a given type of loss occurs.

00:29:44.600 | So a good example of a loss prevention measure would be doing something like locking your doors on your vehicle when you leave it.

00:29:56.600 | So this would be a loss prevention measure.

00:29:59.600 | And then the loss reduction measure, a loss reduction measure would refer to a risk control measure that aims to reduce the severity of a loss.

00:30:07.600 | And these will usually be very closely related.

00:30:11.600 | So you may choose to build a house that is built out of, a house or an office building that's built out of concrete instead of wood so that it's more fire resistant.

00:30:21.600 | You may choose to install a security system in your house to reduce and prevent the loss of items due to theft with the security device.

00:30:31.600 | You might get an annual physical exam from your physician in order to reduce the potential, to reduce the potential for having a disease that's far advanced,

00:30:43.600 | to prevent it and then also to reduce the severity.

00:30:46.600 | Perhaps you can find the cancer when it's in the early stages and it's more easily treatable.

00:30:51.600 | You might wear your seat belts in the car and, again, lock the doors when you leave.

00:30:56.600 | You might wear a safety device when you're operating something with the potential for loss.

00:31:02.600 | So if you're operating a lawnmower, you would make sure that you keep the guard in place.

00:31:06.600 | You would wear appropriate eye protection and hearing protection and foot protection.

00:31:12.600 | And this would be designed to either prevent the risk, so perhaps by having the appropriate guards in place,

00:31:17.600 | you can prevent the risk of a stone being thrown out and hitting your leg.

00:31:20.600 | And then it would also be designed to reduce the risk.

00:31:22.600 | So by wearing the face shield, you may not be able to prevent the stone being kicked out at you and hitting you in the face, but you can reduce the impact.

00:31:31.600 | Whereas instead of that stone going directly into your eye and causing the loss of your eye, it may just simply cause a bruise by hitting the glasses.

00:31:39.600 | So these things have to be done basically in advance, and so this is important to develop a mindset of looking to say,

00:31:46.600 | "How can I prevent and reduce the risk of loss?"

00:31:49.600 | So many of these things are just due to prudent thinking.

00:31:53.600 | You make sure that you have a fire extinguisher in the kitchen where it's close in case of a stove fire where you can use it.

00:31:59.600 | You have a fire extinguisher in the garage.

00:32:01.600 | You have a fire extinguisher in your car.

00:32:03.600 | You have to think ahead so that that reduction measure is available.

00:32:07.600 | If you don't have a fire extinguisher handy in your car, then you may sit back and watch the entire car burn in flames and suffer a total loss of the car

00:32:16.600 | instead of just simply having a small electrical fire that you could quickly put out by the use of the fire extinguisher, which is immediately available.

00:32:26.600 | So those are categories number two and three of risk control.

00:32:29.600 | The fourth category would be a non-insurance transfer.

00:32:33.600 | So a non-insurance transfer would use a contract other than an insurance contract whereby you would transfer legal responsibility for a specific activity and any resulting losses to another party.

00:32:47.600 | So the best example of this in my mind would be an example of doing some sort of subcontracting.

00:32:53.600 | Let's say that you are a contractor, but there's a specific type of activity that is going to expose you to a high degree of potential loss.

00:33:01.600 | An example, maybe you're a building contractor, and you desire to put roofs on buildings, but you know that employing roofers is an inherently risky activity.

00:33:12.600 | It's riskier to be on the top of a roof than may suffer the loss of the fall than you as a business owner may be exposed to the risk of caring for that employee who fell off the roof.

00:33:23.600 | Well, if you're a roofing contractor, you can hire a – excuse me.

00:33:26.600 | If you are a building contractor, then you can choose to hire a roofing subcontractor in order to transfer the risk of your – of his – from – in order to transfer the risk of the employee falling off to be from you to be to him.

00:33:40.600 | And so this would allow you to reduce your exposure to a certain type of loss.

00:33:45.600 | Or even on a homeowner basis, I know that I think more about this than I ever did.

00:33:49.600 | I've always done my own roofing.

00:33:51.600 | I've always done my own tree trimming, things like that.

00:33:53.600 | Nowadays, though, as I'm getting older and potentially a little bit more conservative, I start to think, "Well, if I'm way up here on this ladder, 15, 20 feet in the air trimming my palm trees, is this really worth it to me if I were to fall off this ladder to save the 50 bucks or the 100 bucks or the 300 bucks that it would just simply cost me to hire somebody to trim my trees for me?"

00:34:14.600 | And increasingly I consider that and I – more than I ever have in my life, I see the value of transferring that risk through a contractual relationship where instead of me having to be up at the top of that ladder trimming those – trimming those trees, I may be happier to pay and transfer that risk to the tree trimmer – the risk of falling and injuring myself to the person who's trimming the trees professionally.

00:34:39.600 | So those would be four methods of risk control and all four of them are useful and applicable and they're going to kind of work together.

00:34:48.600 | Then you would get into risk financing methods.

00:34:51.600 | This is the other major category of handling risks.

00:34:54.600 | And risk control is designed to lower the impact of losses with the exception of risk avoidance which just simply eliminates the possibility of the loss.

00:35:06.600 | But many of the risk control methods are designed to lower the impact of the loss whereas risk financing is designed to pay for the loss even if it still occurs.

00:35:17.600 | So we're going to assume that it happens and we're going to try to exert some way to control the loss but then we're still going to – we're still going to make sure that we have a way to pay for it.

00:35:27.600 | So we're going to lock the doors on the car and that's hopefully – and install an alarm device and hopefully that will reduce the risk.

00:35:35.600 | But if the car is still stolen, we need to finance it.

00:35:37.600 | So we're going to get into financing methods.

00:35:39.600 | And there are two fundamental major types of financing methods, risk retention and risk transfer.

00:35:46.600 | So risk retention is where we just simply retain the financial burden of a loss that occurs instead of transferring it to some other party or to an insurance company.

00:35:57.600 | And risk retention could be either a planned program or an unplanned program.

00:36:04.600 | A planned form of risk retention would be a purposeful, conscious, intentional, and active behavior.

00:36:11.600 | So as an example, I may evaluate a specific risk that has a high frequency but a low severity and I just may decide, "You know what?

00:36:20.600 | I'm going to keep – I'm going to retain this specific risk."

00:36:24.600 | So I may – this may be something as mundane as I'm going to choose to take the fact that it's very possible that I'm going to blow out a tire.

00:36:35.600 | This is not necessarily an infrequent occurrence and/or my tire could become flat.

00:36:40.600 | But it has a pretty low severity to me in my house and my household income.

00:36:44.600 | So if the tire goes flat, I'll just change it and get it fixed so I don't need to transfer that risk of loss over to the tire manufacturer through the use of their insurance contract.

00:36:55.600 | I'll just retain the risk.

00:36:56.600 | Now, an unplanned risk retention is actually extremely common.

00:36:59.600 | And so many risks would be retained simply because the existence or the significance of the risk is not known to the person who is experiencing the risk.

00:37:08.600 | Perhaps the person has a lack of knowledge about their exposure to the risk or that they are just simply unable to decide how to handle it.

00:37:19.600 | A good example here would be something like long-term care insurance.

00:37:24.600 | Unless you've gone through a long-term care insurance event with a family member, it's very unlikely that you don't actually have a fair understanding of the need for long-term care and the specific cost of long-term care.

00:37:39.600 | Or you just might not know that you can buy insurance for it.

00:37:41.600 | So you might just have an unplanned risk retention program.

00:37:46.600 | And this could be, again, from unintentional action just because you're lazy or you don't maybe research the possibilities.

00:37:54.600 | It could be from many factors.

00:37:57.600 | So a lot of people, they've been meaning to get around to buying life insurance, but they really don't want to talk about it.

00:38:03.600 | So very few people will actually pick up the phone and call a life insurance agent.

00:38:07.600 | The majority of a business that a life insurance agent will write happens because a life insurance agent calls somebody.

00:38:13.600 | And they know the risk is there.

00:38:14.600 | They know they've got this risk, and they've been retaining it just because they just don't want to get around to it.

00:38:19.600 | And then until the insurance agent shows up on their doorstep, that's when they go ahead and make the decision.

00:38:25.600 | Sometimes you might just simply retain a risk because it's just relatively unimportant or because there's no possibility of transferring it.

00:38:34.600 | So you may very much choose to say, "I'm going to keep this risk."

00:38:40.600 | A good example here would be the contracts that are available when you purchase a new piece of electronic equipment.

00:38:46.600 | So if you go and you buy a TV, they're going to offer you a contract on the TV that's available to you where you can, if the TV breaks, return it.

00:38:55.600 | And they will fund it out with an extended warranty.

00:38:58.600 | You may look at it and say, "This risk is simply unimportant to me.

00:39:01.600 | I have the money to buy the TV.

00:39:03.600 | And if the TV broke tomorrow and I had to buy another one, this would not be a major factor in my life.

00:39:09.600 | So therefore, I'm just going to retain the risk."

00:39:12.600 | And that's perfectly acceptable.

00:39:14.600 | In fact, most consumer advocates would recommend to you that you retain that risk because of the cost of the insurance contract.

00:39:20.600 | They just say the probability is low, the severity is low, and therefore they would say retain the risk.

00:39:25.600 | On the other hand, you may have a specific risk that you're aware of, but you just simply--there's no way to transfer the actual--there's no way to transfer the risk.

00:39:36.600 | So long-term care insurance--I've had many clients that I worked with who wanted to buy long-term care insurance because they felt that they were exposed to a risk of long-term care.

00:39:46.600 | And they wanted to transfer that risk to an insurance company, but they were just simply unable to transfer the risk because the insurance company wouldn't accept the contract.

00:39:55.600 | So therefore, the financial plan changes, and we just simply acknowledge that, that we cannot transfer this risk.

00:40:01.600 | So now we have to deal with another way to actually control it, minimize it, and plan for it and finance it in some way that doesn't include insurance.

00:40:12.600 | Another example, let's say that you are unhealthy and you're fat, you're unhealthy, you have high blood pressure, and you had a stroke.

00:40:18.600 | You're not going to get life insurance, so therefore your family may still need the insurance protection, but we cannot actually transfer it to an insurance company.

00:40:30.600 | When you are retaining a risk, it's important to calculate your actual personal loss exposure and make sure that your risk retention plan is going to be sufficient for that.

00:40:41.600 | So there are different ways. Remember, we're in risk financing, so we're going to finance this in some way.

00:40:47.600 | And in the examples here where we're going to retain the risk, we've got to figure out how we're going to finance this out of pocket.

00:40:53.600 | One way to retain risk that's fairly common would be adjusting things like a deductible.

00:40:58.600 | So most of you would be familiar with how insurance policies work from the purpose of a deductible.

00:41:04.600 | If you are purchasing a health insurance policy to cover the cost of your medical costs, now you're going to look at it and say, "Do I want a $300 deductible or a $3,000 deductible?"

00:41:17.600 | If you choose the $3,000 deductible, you are retaining more of the risk for the cost of your health expenses than if you choose the $300 deductible.

00:41:27.600 | So a deductible is a form of partial risk retention.

00:41:31.600 | This is why -- and this is an excellent way to start.

00:41:34.600 | If you go through all of your insurance policies and you've saved up another source of funding and you raise all of your deductibles,

00:41:41.600 | you may have the ability to increase the deductible and save a substantial amount on the premiums because you are retaining the risk that you previously were transferring to the insurance company.

00:41:54.600 | And so because now the insurance company has less of the risk, they're able to charge you less.

00:41:59.600 | That's fundamentally how this works.

00:42:01.600 | In order for you to make that decision in an intelligent way, you need to make sure that you have the plan in place to cover that deductible.

00:42:09.600 | And so a deductible is a standard way to retain more of the risk by increasing the deductible.

00:42:16.600 | You may just simply choose to retain the risk by absorbing it into your ongoing monthly expenses.

00:42:23.600 | So, you know, and this doesn't matter whether it's in a business or in a family.

00:42:28.600 | So in a business, maybe you have just ongoing substantial excess cash flow.

00:42:33.600 | And so if you had a situation where there was a large expense, you have enough excess cash flow to cover it.

00:42:40.600 | In a family, if you have a high degree of margin available in your budget, your expenses are -- you know, your income is $10,000 a month and your fixed expenses are $4,000.

00:42:49.600 | That gives you $6,000 of margin.

00:42:52.600 | So now you can absorb more of the unexpected losses.

00:42:56.600 | So let's say that you had an unexpected root canal that you needed.

00:43:02.600 | Well, with this unexpected root canal, you can just simply pay for that.

00:43:05.600 | This costs you $2,000 out of pocket.

00:43:07.600 | You can absorb that easily in a monthly budget.

00:43:10.600 | You need a new set of eyeglasses.

00:43:12.600 | You can easily absorb the $500 for the monthly budget.

00:43:15.600 | However, if you do not have the margin in your budget, your monthly income is $5,000 and your monthly expenses are $4,999, then now you've got a problem.

00:43:29.600 | Where is the plan going to come for that $500 eyeglass bill or that $2,000 deductible?

00:43:35.600 | So one of the most important reasons to build up savings in your own personal financial plan is that it allows you to maybe retain some of the risks that you feel you're at a low -- that are at a low risk for you because you have the cash for them.

00:43:50.600 | But the less money that somebody has and less margin, the more important the insurance actually can be.

00:43:56.600 | So this is one of those counterintuitive planning techniques is that oftentimes people who have the least amount of room available in their budget need the most insurance, whereas people who have a lot of room in their budget, they can go ahead and retain the risks and just simply absorb them in their operating costs.

00:44:12.600 | You may need to set aside an actual fund or a reserve account.

00:44:16.600 | So for a family, usually we would refer to this as an emergency fund.

00:44:20.600 | And how big should it be?

00:44:22.600 | Well, that depends on what the actual risks are.

00:44:25.600 | So the numbers would vary for family depending on what the actual expected risks would be.

00:44:31.600 | The numbers that we make up, six-month expenses, three-month expenses, these are just numbers that we make up that are probably good enough to give people a simple goal to get to.

00:44:40.600 | But if you're going to retain a specific risk that is much higher, you may need a much higher reserve fund.

00:44:46.600 | And this is very challenging to actually figure out how it can be calculated.

00:44:53.600 | So the disadvantage of just simply retaining a risk and funding it with a reserve account is that there's often not a guarantee that the cash is going to be available when the loss occurs.

00:45:04.600 | So, A, how large should the fund be?

00:45:07.600 | Two, how do we accumulate the money even in spite of the fact that we could have a loss before we've accumulated enough money?

00:45:14.600 | And number three, how do we keep the fund there without taking the money out to use it on another emergency or using it just in our regular operations?

00:45:23.600 | And this -- you see this a lot in family emergency funds is that this is earmarked as the family emergency fund, but then we have a situation that is an emergency, and then there's another emergency.

00:45:32.600 | And then there's an unplanned expense that we just -- it's not quite an emergency, but we need it.

00:45:37.600 | And now the emergency fund is wiped out.

00:45:39.600 | So that would be a -- one of the disadvantages of accumulating the fund and why some risks that you might be exposed to you might need to transfer.

00:45:50.600 | And all of this would be relative to your specific situation.

00:45:53.600 | Now, you could also do this not with necessarily a savings fund, but you could do this with access to a line of credit.

00:46:01.600 | So some sort of credit arrangement is certainly a reasonable way to retain some amount of risk.

00:46:08.600 | Businesses will do this routinely.

00:46:10.600 | You have a line of credit available to you.

00:46:12.600 | If you have some short-term risk that happens, you just simply transfer the money over and take the money from the line of credit.

00:46:18.600 | So for an individual, this may be a good idea as well.

00:46:20.600 | So having a line of credit available to you on your house may give you, in the event of an emergency, access to the money that you need to fix the house.

00:46:28.600 | So if you have a $50,000 line of credit available on your house, and then you have $20,000 deductible down here on your hurricane policy,

00:46:38.600 | then this may be a good way for you to acknowledge that I'm going to go ahead and use this line of credit to cover my deductible on my hurricane policy.

00:46:49.600 | Or maybe this would be access to always keeping some credit cards available, where you have a line of credit available to you on a credit card that is pre-negotiated and you've got that available.

00:47:00.600 | So that would be another method of funding it.

00:47:02.600 | The next type of just retention would be self-insurance.

00:47:07.600 | And so self-insurance is somewhat sloppily used in personal finance, and that's okay.

00:47:14.600 | I think it doesn't have to be -- we don't have to be so precise in everything.

00:47:21.600 | But if you're coming at it from an academic perspective, then the proper use of self-insurance would be only applied to a formal program of risk retention.

00:47:32.600 | So a large company would choose to self-insure their medical costs.

00:47:38.600 | Well, they need to have a formal program set up to cover that out of their -- where they're simply acting like an insurance company.

00:47:50.600 | In the personal finance world, people will usually use this term to simply mean something like, "Well, I have a million dollars, so therefore I don't need my million dollars of life insurance anymore."

00:48:00.600 | Is that self-insurance?

00:48:02.600 | Depends. It's good enough for me, but that wouldn't technically be the academically correct way, and that would make somebody -- unless there were a formal --

00:48:11.600 | and here's the problem with using it in that term is that, A, has it been actually formally calculated where we know that this million dollars is the correct number?

00:48:20.600 | And then if it has been formally calculated, are there any other requirements pulled on the money?

00:48:27.600 | And so if you have a million dollars and that's going to provide for your spouse's standard of living, then what about the college education costs?

00:48:40.600 | Because you're counting the $200,000 that you have earmarked for your kids' college education costs as part of that money.

00:48:46.600 | That's a perfectly legitimate choice to make to say, "Well, if I died, then I'm okay with not paying for the college education costs, and I'm willing to make that choice."

00:48:58.600 | Entirely legitimate. It's your money. You can make that choice.

00:49:01.600 | But this term for me is thrown around a little bit sloppily in the common personal finance vernacular.

00:49:10.600 | So there's my little pet peeve, I guess.

00:49:14.600 | Now, let's go on. Those are all methods of risk retention.

00:49:18.600 | What about risk transfer?

00:49:20.600 | And with risk transfer, there are two ways to transfer risk, or at least two categories that we use in kind of the formal technical side of financial planning.

00:49:29.600 | We would do a non-insurance transfer and insurance.

00:49:33.600 | So a non-insurance transfer, we already mentioned it in risk control, where in the example of using a non-insurance transfer to transfer the risk from a contractor to a subcontractor.

00:49:44.600 | But here we're talking about financing.

00:49:46.600 | So when it's used as a risk financing method, then what we're transferring is the actual financial burden of losses, not just the legal responsibility that we did in the risk control mechanism.

00:50:00.600 | So the example here would be, do you purchase an extended warranty when you buy a vehicle or a new appliance for your house?

00:50:08.600 | Do you buy the extended warranty?

00:50:10.600 | That doesn't transfer any liability, but it does transfer the risk of any potential loss.

00:50:17.600 | Therefore, if you buy the extended warranty on the car and the car breaks, now the provider on the other end of the contract has the need to fix the car.

00:50:26.600 | So that transfers the financial risk.

00:50:30.600 | This is where a lot of people get into arguments.

00:50:32.600 | And if you're giving good consumer advice, you've got to look at it and you've got to figure out, is this an efficient way to do it?

00:50:39.600 | And it may or may not be an efficient way to do it.

00:50:41.600 | You've got to actually look at the actual contract, look at the counterparty, because you've got to understand if the counterparty is actually strong enough to handle it.

00:50:50.600 | But it's one way to handle the financial consequence of the risk of the car breaking down.

00:50:55.600 | There would also be something like a hold harmless agreement.

00:51:00.600 | So maybe you establish a hold harmless agreement between you and somebody that you are renting property to.

00:51:08.600 | And then this hold harmless agreement deals with transfers all of the financial risk with your liability to the person with whom you are establishing the agreement.

00:51:20.600 | This would be common in a lease contract.

00:51:22.600 | So if you read a lease contract, you'll see various legal responsibilities and their associated costs that are transferred from one party to another.

00:51:31.600 | Then the second way under this category of actually transferring the risk of the financing would be insurance.

00:51:40.600 | And insurance is definitely the most common risk financing method, but it's not always the best.

00:51:47.600 | It's only available for some types of risk and it's not always the best.

00:51:51.600 | And that's why I have gone through all these different methods.

00:51:55.600 | If you look at the risks that are in your life, you can find different ways to deal with them.

00:52:01.600 | You can, if you're thinking about insuring your, in Florida we're not required to insure motorcycles under our law.

00:52:11.600 | So I can choose to have a motorcycle that doesn't have insurance.

00:52:16.600 | I could either choose to buy the insurance and transfer the risk to the financing of a loss on the motorcycle to an insurance company.

00:52:26.600 | Or I could avoid the risk of loss under the risk control mechanism by just simply getting rid of the motorcycle.

00:52:32.600 | It sounds silly when I say it, like duh, but people don't often think about this.

00:52:36.600 | And if you have this framework as a mental framework, then you can look at the risks that you're exposed to in your life and you can make an appropriate decision for them.

00:52:45.600 | So I'm going to review these methods just in summary so that you can hold them in your mind.

00:52:51.600 | Then I'm going to go through kind of a mental framework that we use in the insurance business where we talk about the frequency of the loss and the severity of the loss to try to figure out what would be an appropriate way to handle the risk.

00:53:04.600 | So again, two fundamental categories, risk control and then risk financing.

00:53:10.600 | Risk control is all about affecting the actual risk, and then risk financing is all about the method of payment in case of loss.

00:53:18.600 | Risk control has risk avoidance, which is where we completely eliminate the risk.

00:53:23.600 | We choose not to fly in airplanes, and thus we avoid the risk of the plane going down.

00:53:27.600 | Then you have loss prevention and loss reduction, which are closely connected, where you seek to establish methods to reduce the risk and then use--excuse me, to prevent the risk in the first place and then to reduce the risk.

00:53:41.600 | So you would choose to lock your doors and you would install a security system to prevent the risk of your vehicle being stolen, and then you would install a GPS tracking device of some sort in order to reduce the loss where maybe you can get the car back more quickly.

00:53:58.600 | So loss prevention and loss reduction.

00:54:00.600 | And then you would have a non-insurance transfer, which is where through the use of a contract or the use of a business relationship, you transfer the risk, the actual risk, to another party.

00:54:10.600 | So I transfer the risk of falling off my roof to the roofer and I stand back and watch them and I pay them for that service.

00:54:17.600 | Those are all ways to actually control the risk.

00:54:20.600 | Then to actually finance the risk, we either choose to retain the cost or to transfer the cost.

00:54:27.600 | If we're going to retain the cost, we need to have some sort of funding mechanism set up for it, whether that's a reserve fund or a line of credit or just that we're going to absorb it into our monthly cash flow.

00:54:38.600 | If we're going to transfer the risk, then we either need to transfer it through the use of a contract that's not an insurance contract or through the use of an insurance contract or transfer it to another party.

00:54:49.600 | Now, when you're figuring out what you should do at different points in life, it's going to be fairly apparent.

00:54:55.600 | And I would encourage you to consider all the risks and consider all the different ways that you can handle them.

00:55:02.600 | You can't – all is too big of a word, I think.

00:55:06.600 | It's tough to say I'm going to figure out all of the risks in my life.

00:55:10.600 | But when you notice a risk that you have in your life, consider is there a way that you can deal with this.

00:55:15.600 | If you notice the risk that you drive – I've often – throughout my life, I've always driven relatively older cars.

00:55:22.600 | So I have the risk of my car breaking down and leaving me on the side of the road.

00:55:29.600 | Well, how do I deal with that risk?

00:55:31.600 | I'm going to try to control the risk by keeping the car in good working order, doing preventive maintenance, things like that.

00:55:38.600 | And then I'm going to try to – so that's part of a loss prevention plan.

00:55:44.600 | And then I'm going to try to reduce the impact of that loss by making sure that I have some emergency supplies with me in the vehicle in case I get stuck on the side of the road in a rural area and the car breaks down on me in a rural area where I don't have any food and water.

00:55:57.600 | So I'm going to keep some food and water in the car.

00:55:59.600 | I'm going to try to make sure that I have a tow strap in the car where somebody can tow me if I need that.

00:56:05.600 | And then I may go ahead and choose to do a non-insurance transfer of the risk of the cost of the tow bill from me and my checking account to AAA.

00:56:17.600 | And I did this for years when I drove an older car because I didn't want to have the potential for a $250 towing bill.

00:56:24.600 | And I knew I had a risk, so I was trying to transfer that risk of the towing bill from me to AAA.

00:56:29.600 | So this is a day-to-day situation that we face.

00:56:34.600 | And the reality is that most of the risks that we face, it's a good idea to put in place all of these procedures, either just simply avoid the risk.

00:56:43.600 | So maybe I would avoid the risk of taking my older sort of beat-up, dilapidated car on a long cross-country road trip.

00:56:50.600 | I would go ahead and avoid that risk by doing a rental car.

00:56:53.600 | And then we're going to prevent it, reduce it, reduce the impact of it, and then we're going to do a transfer of the risk or we're going to choose to retain the risk.

00:57:00.600 | And this is where just the day-to-day – I did the show recently on a mindset of preparedness as a fundamental core of financial planning being so important.

00:57:09.600 | This is where things like making sure that you have fire extinguishers.

00:57:13.600 | This is so fundamentally important, but do you have a fire extinguisher in your car that's easily available in case your car brake catches on fire or somebody else's car catches on fire?

00:57:23.600 | A small electrical fire can be very quickly dealt with with a fire extinguisher, whereas if there is no fire extinguisher, again, you may stand back on the side of the road and watch the entire car take flames, burn itself up.

00:57:36.600 | Simple things like making sure that you have some emergency lighting in your home can make all the difference in the world if the power goes out.

00:57:44.600 | So very, very simple ways to deal with the risk.

00:57:47.600 | Now, with regard to insurance, we're trying to figure out what is the different – what are the things that we should insure?

00:57:55.600 | And there's a useful mental construct that we use to kind of make a little chart, and it's basically – this is not universally applicable, but I find it to be useful –

00:58:04.600 | is that what risks do we retain and what risks do we avoid and what risks do we insure?

00:58:10.600 | So we can classify some risks on the basis of their frequency and their severity.

00:58:17.600 | So imagine in your mind a chart showing the expected frequency of a loss on one axis, on the Y axis up and down, and then the severity of the expected loss on the X axis, left and right.

00:58:33.600 | And so you've got a quadrant – you've got a four box – four-quadrant box that has high losses, expected losses, with a high expected frequency and then a low expected frequency.

00:58:46.600 | And then you've got losses that are a high loss – severity of loss and a low severity of loss.

00:58:54.600 | So for any risk that has both a high frequency of loss and a high severity of loss, then the most suitable technique there would be to avoid the risk.

00:59:06.600 | If there's a high frequency and a high severity, we cannot take this risk, so we're going to avoid it.

00:59:11.600 | You can't retain the risk because if it's a high frequency and a high severity, that may bankrupt you, and you're not going to be able to buy insurance because it's going to cost you way too much money even if it's available.

00:59:22.600 | So you have to avoid it if it's high loss frequency and high loss severity.

00:59:28.600 | Now, depending on the risk that we're talking about, it might not be possible to avoid it.

00:59:35.600 | If it's not possible to avoid it, then you must focus on implementing loss prevention or loss reduction measures in order to reduce the frequency or the severity to a more manageable level.

00:59:49.600 | If you can get it down to a more manageable level, then you might be able to implement one of the other methods.

00:59:56.600 | So if you can reduce – many times in property and casualty insurance, less so in personal insurance, but many times in property and casualty insurance, the insurance company will work with the business.

01:00:06.600 | And if there's a risk that has a high frequency and a high severity, then if the business will implement enough risk control methods to prevent the loss or to reduce the loss, then the insurance company will go ahead and provide an amount of insurance.

01:00:24.600 | Or they may insure part of the risk through a reinsurance program where the business goes ahead and retains some of the risk.

01:00:31.600 | So if the risk is a high frequency or a high severity, you've got to avoid it.

01:00:36.600 | And if you can't avoid it, then you've got to focus on kind of getting it out of either high expected frequency or high severity through preventing it or reducing it.

01:00:46.600 | Now, if your risk has a high potential loss frequency and a low loss severity, then usually the most suitable technique for you to employ here is retention, retaining the risk.

01:01:00.600 | If you can implement a loss prevention measure, that would be a good idea because then that might reduce the frequency.

01:01:07.600 | But generally, these are risks that are perfectly adequate to retain.

01:01:12.600 | So if you have a risk, again, high frequency, low severity, what would be a suitable example of this?

01:01:18.600 | A suitable example would be -- I guess the only one that comes to mind right off the bat would be my grandfather, who was a farmer out in Colorado, would always seem to have cracked windshields in his car any time I would be there.

01:01:34.600 | And he'd have multiple chips and dings and cracks.

01:01:36.600 | Well, he spent all of his time driving on gravel roads, and it was almost constant that he would have a cracked windshield.

01:01:45.600 | Now, if I had a cracked windshield in West Palm Beach, Florida, I've never had a rock hit me and break my window.

01:01:51.600 | So to me, that would be a different scenario.

01:01:53.600 | But for him, hey, it always happens.

01:01:55.600 | There's a high frequency, and it really wasn't a big deal to him.

01:01:59.600 | A low severity, he'd just deal with the glass chips.

01:02:02.600 | And then from time to time, if he needed to get a new windshield, he'd get a new windshield.

01:02:06.600 | So he would just simply retain the risk.

01:02:08.600 | It certainly wasn't worth it for him to have a low deductible on his automobile insurance, low enough to where every two months when he would get another rock chip in it, that they would fix the windshield.

01:02:18.600 | It's probably not a great example, but that's the best one I can come up with off the top of my head.

01:02:21.600 | So that would be -- if it's high frequency, high severity, you have to avoid it.

01:02:28.600 | If it's a high frequency and a low severity, you're just going to retain it probably.

01:02:33.600 | And then work on a way of controlling it to reduce the frequency through some sort of loss prevention measure.

01:02:40.600 | Now, the third category would be risks that have a low loss frequency and a high loss severity.

01:02:50.600 | So low frequency and high severity.

01:02:53.600 | In these cases, insurance is usually going to be the most suitable technique.

01:02:58.600 | Retention of a risk that has a low frequency and a high severity is usually tough because if that happens, it may be a wipeout risk.

01:03:11.600 | And it's infrequent.

01:03:12.600 | Because it's infrequent, it's probably suitable for insurance.

01:03:15.600 | So that's basically the most suitable category is for things that are insurable.

01:03:21.600 | The cost of insurance should be manageable in cases of low frequency because it's going to be spread out over a large number of people.

01:03:29.600 | And because it's low frequency, it's unusual.

01:03:31.600 | So probably the actual cost of the insurance is going to be low.

01:03:35.600 | So low frequency, high severity, usually here we're going to insure it because we're going to use the law of large numbers.

01:03:41.600 | We're going to share the risk among many participants, and that's going to keep the cost fairly low.

01:03:47.600 | Fourth category is risks that are low frequency and low severity.

01:03:51.600 | And so again, here the most suitable technique would just simply be to retain them.

01:03:58.600 | If the risk is low frequency and low severity, it's usually not a big deal.

01:04:01.600 | The losses really don't happen very often.

01:04:03.600 | And when they do, the consequences are simply not that big of a deal.

01:04:08.600 | I hope that that framework gives you a useful starting point in considering your own situation and trying to figure out what you should do when you're looking and considering a risk that you face in your life.

01:04:25.600 | A lot of times, see, many people view the only way to handle risk is insurance.

01:04:29.600 | And insurance is a wonderful way to handle risk if that risk is a high severity and a low frequency.

01:04:35.600 | It's not a great way to handle some other types of risk.

01:04:38.600 | And there's often insurance is simply not available.

01:04:41.600 | So if it's speculative risk instead of a pure risk, then insurance is not available.

01:04:45.600 | So insurance has to – is only available in a specific number of areas to cover the risk.

01:04:52.600 | I will go through in detail lots of different ways to do insurance planning in the future.

01:04:58.600 | But I wanted to start here because a good risk program, a comprehensive risk program will include far more than insurance.

01:05:04.600 | The challenge that you always have to face is that those of us who are insurance agents, we are naturally going to be talking to you about risks to which we can sell an insurance policy.

01:05:13.600 | And hopefully if we're doing a good job, we're going to try to point out to you other risks.

01:05:17.600 | But many times it's simply not in our interest to spend three hours talking to you about all the risks that are in your life that don't involve the use of an insurance policy.

01:05:27.600 | So with this, however, you should be able to look at your own situation, your own scenario, and design a risk program for yourself.

01:05:36.600 | Pretend that you are assigned to be the chief risk officer for your family's – for all of your family's risks.

01:05:43.600 | In that scenario, what would you be concerned about?

01:05:46.600 | Well, you would be concerned about losing your job.

01:05:49.600 | You would be concerned about medical costs.

01:05:51.600 | You would be concerned about your child falling and breaking a leg.

01:05:54.600 | You would be concerned about getting burned on the stove.

01:05:57.600 | You would be concerned about the stripped insulation on an electrical wire in your house burning down.

01:06:02.600 | You would be concerned about how do you invest to minimize the risk of loss.

01:06:07.600 | You would be concerned about providing for yourself when you're old and perhaps feeble and unable to work to provide for yourself.

01:06:13.600 | You would be concerned for the risk of losing your marriage.

01:06:16.600 | You'd be concerned in going through divorce.

01:06:19.600 | You would be concerned for the risk of living an unhappy life and not achieving your goals.

01:06:26.600 | So all of these things would be risks that you would be exposed to.

01:06:30.600 | And my encouragement, my hope, is that you'll take this framework around risk and be able to implement it into your own life to handle the risks that you're concerned about and that face you.

01:06:41.600 | Think in terms of risk control first and then risk financing.

01:06:47.600 | It's often going to be easier to simply control a risk by avoiding it, preventing it, reducing it, or transferring it.

01:06:57.600 | And it will be cheaper to do that sometimes than to finance the risk.

01:07:01.600 | Once you've gone through a system of risk control, then go to financing the risk and either choose to retain the risk or to transfer it.

01:07:10.600 | And this is the same no matter what.

01:07:12.600 | If you're going to retain a risk, do not retain a risk that you haven't first gone through a program of risk control analysis and assessment.

01:07:19.600 | And then we'll go through more of this in the future as far as how to cover some of these risks with good financial planning.

01:07:27.600 | There's lots of aspects of this, but hopefully this is a useful framework for you to get the discussion out beyond just, "Oh, I bought insurance or I didn't buy insurance."

01:07:37.600 | That's it for today.

01:07:40.600 | I hope this information is helpful to you.

01:07:42.600 | I went fast.

01:07:44.600 | And hopefully it wasn't too dry and academic.

01:07:47.600 | I trust you enjoyed it.

01:07:48.600 | I wanted to get back on the wagon with doing some of these financial planning shows.

01:07:51.600 | I have got a bunch of interviews lined up for you, but this is not what I'm determined.

01:07:55.600 | This show is not going to turn into Interview Hour.

01:07:57.600 | I'm not producing the financial interview shows.

01:08:00.600 | Interviews are awesome, and we've got some awesome guests.

01:08:03.600 | I recorded five interviews yesterday.

01:08:05.600 | Today's Wednesday.

01:08:06.600 | I recorded five interviews yesterday that are going to be released throughout over the coming weeks, and I've got some really great guests as part of that.

01:08:13.600 | I'm excited to bring you their content and their ideas from a broad variety.

01:08:18.600 | But, again, we're not going to be turning this into an interview central around here.

01:08:23.600 | Get your questions, and I will be releasing an interview for tomorrow.

01:08:26.600 | I haven't decided which one I'm going to release, so you'll tune in tomorrow.

01:08:29.600 | I hope you enjoyed the education shows.

01:08:31.600 | I know that's probably not--it's not mainstream, but this background--I'm telling you, this is what my show is about, is this background that most people aren't aware of and don't know about.

01:08:42.600 | This is the background that you need, whether it's designing an educational plan for yourself or for your kids.

01:08:47.600 | If you don't know the history of school, what do you do?

01:08:49.600 | How do you make intelligent decisions around insurance if you don't have some of this background of risk control and risk financing?

01:08:55.600 | That's what this show is about.

01:08:56.600 | I hope you like it.

01:08:57.600 | I hope you see the relevance of it.

01:08:59.600 | I hope it was stimulating to you.

01:09:01.600 | This is stuff that matters, and I really encourage you--I guess I see--the things that I see is how all of these different things that aren't commonly talked about in financial planning really play a massive role in financial planning.

01:09:20.600 | So when you start with a predetermined idea of how big the conversation should be, whether that predetermined idea is--if the predetermined idea is that, "Oh, we're just going to talk about types of insurance," and you're just looking for Joshua's quick five-minute tips on insurance, of what kind of insurance should I buy and how should I pay for it, etc., and where should I structure it and all that, that has its place.

01:09:47.600 | But it's far more powerful if you can apply the idea of insurance to--if you can apply first a method of risk control.

01:09:56.600 | So the same thing with education, and that's why I've gotten feedback that, "Why is this relevant?"

01:10:01.600 | It's not relevant--I ran out of music.

01:10:03.600 | It's not relevant--it's not that it's not relevant for the perspective of--just defining--I'm not trying to make a political argument.

01:10:14.600 | I'm trying to show you how to see through the system.

01:10:16.600 | If you don't see through the system, then you just have what the system says for you.

01:10:20.600 | So see through the system, study the history, study the history of insurance, why was it developed, and then figure out how did people deal with risk before insurance existed.

01:10:28.600 | I did the whole show last Monday on the alpha strategy.

01:10:30.600 | How do you deal with the insurance--the risk of inflation?

01:10:34.600 | And I gave you some of my ideas for how to deal with it.

01:10:37.600 | This type of thinking, I think, will get you farther than just kind of the mainstream financial thought.

01:10:43.600 | So, sorry, I restarted the music there. I've got 2 minutes and 15 seconds.

01:10:47.600 | That's it for today. I hope you're enjoying these shows.

01:10:50.600 | Friday, I'd love to do another Q&A show. I need more questions, though, so please call in questions onto the SpeakPipe app on the website.

01:10:56.600 | Pull it up on your phone. You can do it right from the phone.

01:10:58.600 | You can do it right on your computer using the built-in microphone.

01:11:01.600 | You can do it right on the website.

01:11:03.600 | So just pull it up, click the "Leave a Voicemail" button, leave me a question.

01:11:06.600 | I'd love to do a Q&A show on Friday. I really like doing those, and I hope you like them, too.

01:11:10.600 | We're coming up--today's episode 91. We're coming up on 100 episodes.

01:11:14.600 | And I'm going to try to do a little bit of polling, see what you guys are liking, see what you guys are not.

01:11:19.600 | I'm also working on some ideas. I think I'm going to roll out some sort of membership program.

01:11:26.600 | I'm not sure what to call it, but it's going to be basically, if you like the show and if you would like to support me financially for doing the show, it will be a voluntary contribution to do that.

01:11:36.600 | It's not just going to be a donation. I'm going to work out a member support site with benefits, additional benefits for you.

01:11:42.600 | I'm going around as far as the amount of money. Right now, I'm thinking I'll set something up for just under $10 a month.

01:11:49.600 | That's kind of what I'm thinking. I don't know if that's right or not.

01:11:51.600 | But I think I can provide a really awesome group of benefits for you, and that will allow me to be able to give more attention and focus on the show.

01:11:59.600 | I'll be rolling that out, and I'll give you all of my framework and give you some background.

01:12:03.600 | So coming up on episode 100 pretty soon, and I will roll that out for episode 100.

01:12:07.600 | It'll be a little bit sparse in the beginning, but that will be my primary focus. I'm pretty excited about that.

01:12:12.600 | Thank you for the reviews. Please, if you like today's show, subscribe.

01:12:17.600 | I think you'll like some of these interviews that I've got coming up in the next few days.

01:12:22.600 | Thanks for listening, everybody.

01:12:24.600 | [Music]

01:12:52.600 | Thank you for listening to today's show.

01:12:54.600 | This show is intended to provide entertainment, education, and financial enlightenment.

01:13:02.600 | Your situation is unique, and I cannot deliver any actionable advice without knowing anything about you.

01:13:10.600 | This show is not and is not intended to be any form of financial advice.

01:13:17.600 | Please, develop a team of professional advisors who you find to be caring, competent, and trustworthy,

01:13:27.600 | and consult them because they are the ones who can understand your specific needs, your specific goals, and provide specific answers to your questions.

01:13:38.600 | Hold them accountable for your results.

01:13:41.600 | I've done my absolute best to be clear and accurate in today's show, but I'm one person, and I make mistakes.

01:13:48.600 | If you spot a mistake in something I've said, please come by the show page and comment so we can all learn together.

01:13:55.600 | Until tomorrow, thanks for being here.

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01:14:25.600 | (upbeat music)

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