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As your wealth and income grow, your focus may shift to finding a balance between asset growth and preserving what you have accumulated. At this stage in life, most people would have been quite settled with less burden on financial resources. No more mortgages to pay, children graduating and leaving home etc. And you may be thinking more seriously about comfortable retirement.
Insurance provides an important means of meeting the financial objectives of most people. But to understand how insurance may be useful in meeting a person's financial objectives, it is helpful to look first at the broader field of risk management.
The term risk management normally means the use of all alternative methods of dealing with risk. Although most people are perhaps less able to implement these techniques in a “personal risk management” situation, the knowledge of this concept can assist them in developing the proper philosophy toward handling the personal risks they face.
Risk management, in its simplest form, consists of knowledge of the existence of various forms of risk and their magnitude and the management of the various methods in dealing with those risks. The first steps in the risk management process are risk analysis and risk evaluation.
Risk Analysis. The logical start of any risk management programme is the recognition of one's risk exposures. This may not be as easy as it seems at first glance.
Risk evaluation. Once a risk is discovered, it should be evaluated to determine its cause and the probable degree of control that may be had over it.
Basic Risk Management Techniques
Risk Avoidance is simply the act of eliminating risk by avoiding the causes of risk. As an example, one may choose not to drive in order to avoid the risk of auto liability. Of course, such drastic measures are not necessarily recommended in dealing with risks of this nature. In some cases, however, risk avoidance may be quite logical such as stop smoking to avoid lungs cancer.
Risk Reduction or Damage Control. This mainly consists of all activities intended to prevent the occurrence of a loss (damage control). In addition, it includes those steps taken to minimize a loss should one occur (risk reduction). An example of the former would be the removal of inflammable materials such as paints, thinners or petrol from inside the house to minimize the risk of fire to the house. An example of the second would be placing a fire extinguishers in certain areas of the house to control a fire should one occur.
Risk Retention is the conscious act of keeping or assuming a risk rather than transferring it. In some cases, such as the risk of loss from war or terrorist acts, retention is the only practical method of handling the risk, since insurance usually can not be purchased for such risks.
Risk Transfer (including insurance) consists of any measure by which the risk of one party is transferred to another. Insurance is the most important type of transfer device and usually is defined as the transferring of risk to a third party (the insurance company) in return for the payment of an amount of money (the premium).
The Insurance principle
Although not all risks are insurable but there are many potential events such as fire, car accidents, robbery, death and disability that can cause substantial losses when they occur. These are the risks that insurance is all about.
In essence, insurance is a means of eliminating or reducing the financial burden of such risks by dividing the losses they produce among many individuals. For example, let's suppose that there are 1,000 individuals age 35, each of whom needs Baht 400,000 of life insurance protection. Assuming that the chance of a person age 35 dying during the next year is 2 out of 1,000. To protect the entire group, each of the 1,000 individuals could agree to contribute Baht 800 into a common fund. This fund would be used to reimburse the families of any individuals who die during the next year. The probability is that two persons will die, and the fund is expected to pay out Baht 800,000 in the next year.
Therefore, for a “premium” of Baht 800, each individual in the group will lose no more than Baht 800, while the risk of losing as much as Baht 400,000, has been substantially reduced. Of course, each of the 998 individuals who did not die during the year could have saved money by not joining the plan but no one knew beforehand which particular individuals would die during the year.
To insure or not to insure
Most people must make decisions concerning which risks should be insured and which risks should be handled in other ways. To help do this, a convenient kind of measure that quickly shows the types of risk that can wipe out an individual or family financially is contained in the following simple formula:
Relative value of a risk = Total amount at stake/Total wealth
Suppose that an individual has a home worth Baht 6 million and a total net worth of Baht 9 million. (6/9= 2/3). Obviously, the risk of the home being totally destroyed by fire is too great for the individual to bear alone, because two/thirds of total net worth could be lost. Thus, the person would be wise to purchase a fire insurance.
The first principle of insurance buying is to place primary emphasis on those risks that potentially could wipe out or substantially deplete the person's or family's net worth. This is sometimes called the “large-loss principle.” Insurance against such losses is considered essential. Note that the severity of a potential loss, not its frequency, should be the determining factor.
Use of Deductibles
Whenever feasible, the use of deductibles should be considered in insurance planning. A deductible requires the insured to pay the first portion, such as the first Baht 3,000, of a covered loss before the insurance comes into play. Use of deductibles can result in several benefits for the insured. First of all, it makes the insurance less expensive, since deductibles eliminate small losses and hence the disproportionately high administrative expenses of settling such small claims. Thus, with a deductible, higher benefits may be purchased or insurance costs may be reduced.
By taking a Baht 5,000 instead of a Baht 2,000 deductible on a car collision insurance, an insured might save enough premium to increase the liability limit from Baht 200,000 per accident to Baht 2 million or more for the same premium.