Personal risk management is a strategy undertaken by an individual to protect his assets against the risks he faces. These risks are separate from the risks that individuals face as investors, like interest rate risk or credit risk. Rather, they are the risks that individuals face because they are people living ordinary lives: the risks of death, fire or other calamities. Each individual has different risks as a result of a variety of factors, including age, location and lifestyle, so each person’s personal risk management strategy must be tailored to meet his specific needs.
There are two main components to personal risk management: prevention and mitigation. Prevention entails taking steps to reduce the likelihood of negative events. For example, washing your hands frequently decreases the probability that you will get sick, so changing your lifestyle to incorporate more frequent washing is thus an example of personal risk management. In some cases, risks can be reduced by an individual’s choices; sometimes a particular risk can be nearly eliminated. If a home buyer chooses a location in Kansas, for instance, he runs almost no risk of facing the full force of a hurricane.
No one can eliminate all risk, however. The Kansas homeowner trades the chance of hurricane damage in Florida for the chance of tornado damage on the plains. There is uncertainty in everyone’s lives. Mitigation techniques, primarily the products offered in the insurance market, reduce the impact that the realization of those risks has on the lives of individuals. Insurance is an important piece of any personal risk management strategy.
The purpose of any insurance product is to share the risk of some event across individuals. Suppose that 1,000 homeowners live in a town. They live in a fairly dry area, and each year one house, which is valued at $100,000 US Dollars (USD), is destroyed by fire. The townspeople make an agreement: in the event of a fire, each homeowner will contribute $100 USD to the cost of rebuilding the house. Now, each homeowner expects to pay $100 USD, but no one fears that he will suffer a $100,000 USD loss.
Insurance works in the same way, except that a company collects the payments and makes the payouts. This company collects fees for organizing the exchange. Instead of collecting the payments at the time of the emergency, they collect them ahead of time according to the expected value of damages. The insured parties know ahead of time what the premium will be. In some periods, the events will happen more often and the company will pay out more; this is balanced by periods in which the events happen more rarely, and the premium is more than the needed level.
By purchasing insurance products, people can mitigate the risks they cannot eliminate. The optimal personal risk management strategy will incorporate insurance at a level that is consistent with the individual’s needs and preferences. It will combine those products with decisions that reduce the probability of the negative events that could befall the individual.