Insurance: the investor’s double-barreled gun
Individual use insurance product for varied reasons and the main idea for using an insurance product are most of the time lost on us. To understand insurance products very well one will need to go back and look at the concept of risk management and how insurance products have become one of the tools in managing risk. Every investor has to, or to put it bluntly, must have some insurance products to mitigate some inherent risk in the system.
It is important to understand the risk management framework as an investor and consider the kinds of risk one is exposed to in investing.
Risk management framework
The risk management process, be it for an individual or for an institution follows the same framework and is made up of the following processes: risk appetite, identification, categorization, measurement, mitigation and monitoring and communication.
Risk appetite goes hand in hand with risk tolerance. Risk appetite defines the amount and type of risk an investor is willing to take and it must be decided at the beginning of any risk management undertakings. Risk tolerance on the other hand is how much risk an investor can cope with and it is a balance between ability and willing to take risk. An investor can have a very high-risk appetite but the risk tolerance on a whole will be very low.
In dealing with Risk Identification; there is a saying that goes that “if you don’t know what you are facing you can’t measure it and there is no way you can manage it.” Risk identification makes it possible for the investor to take stock of all the investment risk they face in the market. Most investors invest blindly with little regard to the kind of risk they face. Some are even not aware of the kind of risk they are exposed to. Considering the MenzGold saga for example, it is obvious that most of the investors in the scheme did not have a clue about the risk they were facing.
Investors need to understand the various categories of risk associated with investment. Risk categorization provide a systematic and structured approach in identifying risk that makes the process very consistent. Risk can be classified as strategic, operational, regulatory, governance and financial. The most important category for the individual investor is the financial risk category. This category is broken down into market risk, credit risk and liquidity risk. Some authors add operational risk to financial risk because of its definition.
Market risk, as defined by some financial dictionary, is the risk that the value of an investment will decrease due to changes in market conditions. These market conditions will have an impact on the performance of investments in the financial market. Market risk is what financial theories call systematic risk because it relates to factors that impact the general market. Market risk can further be broken down into currency risk, inflation risk, commodity risk and interest rate risk. Investors will do themselves a lot of favor if they can understand these risks because those are the risk that drives most of the investments undertaken.
Credit risk is another of the financial risk that bites any investor that plays in the fixed income market. Credit risk is the uncertainty of an investor receiving their principal and interest when due. This is related to default risk and as is said in investment parlance, sometimes you should think of return of investment before you think of return on investment. Assessing credit risk is a weakness of most retail investors and most of the problems associated with investment risk emanate from the fact that flaws in the assessment of this risk leads to investors not demanding an adequate return to compensate for this risk.
Another financial risk is liquidity risk and only materializes when the investor has a sudden need for additional cash flow but investments cannot be easily converted to cash. Liquidity risk makes the quote cash is king very crucial in investing. You can have all the money in the world but if you can’t convert these investments into cash when you need it most then you will have serious problems. Liquidity risk is only apparent when nothing can be done about it.
Operational risk is sometimes captured under financial risk and involves the risk associated with lawsuits, fraud risk and personal problems. This risk is mostly associated with institutions but in relation to the individual investor, it is the uncertainty and hazard associated with living on a day-to-day basis. This is one of the classes of risk that is very difficult to manage without outsourcing it.
When risk is adequately categorized then measurement becomes much easier to do. Without measurement it becomes very difficult to manage the risk. There are a lot of tools for measuring the risk that investors face.
After the measurement of the risk, mitigation is a natural step to follow and fortunately risk mitigation is one of the most developed areas of risk management. There are very simple mitigation procedures as well as very complex ones. In mitigating risk, insurance becomes a very important way of dealing with some types of risk.
Modern portfolio theory indicates that high risk investments should command high return. That is to say that the amount of risk an investor takes should be commensurate to the returns expected. Risk mitigation, therefore, aims at making sure that only risk that is compensated for by expected returns should be accepted. If an investor is not prepared to take risk, then no returns or reward should be expected from such an investment.
Risk mitigation can be carried out in four different ways: risk avoidance, risk transfer, risk control and risk retention. Risk avoidance is the easiest to do. Just avoid the risk that can lead to losses. There is however a caveat here. Because risk and reward go together, by avoiding the risk, you also prevent yourself from benefiting from the reward. You can’t reap where you have not sown. If I don’t want to lose any money in the real estate sector, I just avoid the sector altogether and forfeit the reward I could have gained from the sector.
Risk retention leads to the assumption of the risk with the hope of harvesting the reward from taking such a risk. Risk retention only comes in when the investor is very sure the reward compensates for the risk retained.
Risk control either tries to avoid the risk or control the losses. If the loss from such a risky investment exceeds a set limit, the investment is abandoned or the exposure reduced. Risk control requires a lot of technical know-how and should therefore be left to risk management professionals. The average investor can however venture into this area but the probability of getting your fingers burnt is high.
Risk transfer is another risk mitigating tool that is very effective in managing risk. This is the area of risk management that keeps the insurance industry alive. Risk transfer comes in when the investor cannot manage the risk due to lack of expertise, the risk cannot be avoided and it has little or no reward or the risk is much cheaper to outsource than manage in-house. Let me take a car as an example. When you drive a car there is always the risk of getting into an accident. This risk is however not compensated for and therefore it makes sense to transfer this risk at a cost to you. That is how car insurance functions looking at it from a financial angle.
Insurance and risk transfer
The insurance sector plays a very key role in providing an avenue for the investor to transfer risk that fit into the category of risk that is not rewarded at all or not adequately compensated for and risk that the investor has no expertise is managing. Insurance products are classified into life and non-life.
There are countless of life insurance products but the one that is most important to the investor is general life insurance policy. This is a contract between an insurer and a policyholder in which the insurer guarantees payment of a death benefit to named beneficiaries upon the death of the insured. This means that the bread winners of a household will need to have a life insurance policy in the event of death. This is a case where risk is transferred to an insurance company for the cost of the monthly premium that is paid. Insurers have been very innovative in coming up with funeral and death related products. One such product is the funeral policy that has become so popular. My two-cent advice: before you get any insurance policy, make sure you also have a life policy.
The acquisition of non-life insurance products depends on the value of the assets you want to insure. Some of the non-life insurance products are required by law, example being car insurance. Others such as insuring against flood, fire, theft and a whole range of others depends on the value of those assets. If the value of the assets is high and the loss of those assets will cause a lot of discomfort, then the case can be made for insuring them against losses.
The take-aways from this article are straight forward. The average investor needs to look at risk when investing in the financial market. Risk management takes different forms and that insurance products are one of the most efficient ways of transferring risk for which there is no compensation or the compensation is low compared to the risk or the investor lacks the expertise to manage the risk.