Understanding Risk Management Terms

Despite it's common perception, financial planning is much more than creating a budget, saving money and investing. One of the most important functions in the planning process is to protect assets, capital and the clients way of life.

There are a few risk management strategies that will help you protect what you own and maintain your current standard of living if an catastrophe does occur. However, before we begin to discuss the various risk management strategies, it's important to understand the terms and definitions of the elements of risk planning.

The Definition of Risk

In financial planning, risk is often defined as the “potential of loss”. As uncertain as this world is, there is always a chance that an event could cause the loss of something we value. In this sense loss doesn’t have to be strictly financial. Engaging in dangerous activities places your health at risk. This is due to the fact that there is the potential that you will become injured.

Additional Risk Management Definitions

Probability - The risk management and insurance industry heavily depends on statistical models to assess the probability of losses. Probability refers to the frequency of times an event can or will occur. You can also think of probability of chance, as there can be a large or small chance that something can happen.

Loss - As mentioned earlier, risk is the potential of loss. Loss can be defined as a decline in value, utility or possession. For the purposes of financial planning, loss usually involves the reduction in value of an asset such as a financial instrument (stock, bond, etc.) or property (house, car, etc.).

Exposure to Loss - In consideration of our unique and individual circumstances, we are all exposed to different types of losses. People that do not have a fire extinguisher in their kitchen have a greater exposure to fire losses than those that do.

Peril - The cause of losses are often referred to as perils. Perils can also be referred to as the list of events that could potentially cause loss. Perils include events such as earthquakes, floods, fires, car accidents and theft. Our exposure to perils determines the probability of risk and losses.

Hazards - There are three main types of hazards; physical, moral and attitudinal. Hazards refer to a behavior, incident or act that increases the probability that an loss will occur. Additionally a hazard can also increase the impact or severity of a loss.

Physical hazards include tangible dangers such as an icy road or leaky roof. Moral hazards include behaviors, such as dishonesty, which increases the probability of loss. Finally the last type of hazard is attitudinal, which often consists of the general lack of concern of the consequences of an action.

Risk management is a critical element of financial planning, the terms listed above will help you develop this part of your financial plan.