Page 55 - DMGT515_PERSONAL_FINANCIAL_PLANNING

Personal Financial Planning

Notes 3.5.4 Non-insurance Transfers

Risk can also be managed by non-insurance transfers of risk. The three major forms of
non-insurance risk transfer are by contract, hedging, and, for business risks, by incorporating. A
common way to transfer risk by contract is by purchasing the warranty extension that many
retailers sell for the items that they sell. The warranty itself transfers the risk of manufacturing
defects from the buyer to the manufacturer. Transfers of risk through contract is often
accomplished or prevented by a hold-harmless clause, which may limit liability for the party to
which the clause applies.
Hedging is a method of reducing portfolio risk or some business risks involving future
transactions. Thus, the possible decline of a stock price can be hedged by buying a put for the
stock. A business can hedge a foreign exchange transaction by purchasing a forward contract
that guarantees the exchange rate for a future date.

Investors can reduce their liability risk in a business by forming a corporation or a limited
liability company. This prevents the extension of the company’s liabilities to its investors.

3.5.5 Insurance

Insurance is another major method that most people, businesses, and other organizations can
use to transfer pure risks by paying a premium to an insurance company in exchange for a
payment of a possible large loss. By using the law of large numbers, an insurance company can
estimate fairly reliably the amount of loss for a given number of customers within a specific
time. An insurance company can pay for losses because it pools and invests the premiums of
many subscribers to pay the few who will have significant losses.

Notes Not every pure risk is insurable by private insurance companies. Events which are
unpredictable and that could cause extensive damage, such as earthquakes, are not insured
by private insurers. Nor are most speculative risks—risks taken in the hope of making a
profit.

Self Assessment

Fill in the blanks:
1. Risk is a concept that denotes a potential ..................... impact to some characteristic of
value that may arise from a future event.

2. Risk communication and risk perception are essential factors for all human ......................
3. ..................... is defined as that portion of total variability of return caused by the alternating
forces of bull and bear market.

4. Risk can also be managed by ..................... transfers of risk.
5. Events which are ..................... and that could cause extensive damage, such as earthquakes,
are not insured by private insurers.

3.6 Assessing Risk

It’s one thing to know that there are risks in investing. But how do you figure out ahead of time
what those risks might be, which ones you are willing to take, and which ones may never be

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