Understanding Hazards vs. Risk:
I tend to talk about risks of various hazards and expected value of risk interchangeably -and sometimes wonder if I truly do a good job explaining the differences between understanding hazards vs. risk quantification, so in an effort to clarify, lets dig a little deeper into both.
This post was inspired by Mr. Money Mustache and his analysis of the expected value of owning a small car vs. SUV in his article Safety is an Illusion. It’s great to see someone else who thinks like me.
Quantification of risk can be used in all aspects of life and he gave a great example.
Difference in definition:
A hazard is something that can cause harm, examples include earthquake, electricity, pollution/chemicals, working on a ladder, noise, a keyboard, a bully at work, stress, etc.
The hazards I discuss on certain businesses or personal exposures vary by region, type of business, and/or individual – however, I’m just trying to highlight some of the possibilities for readers. It’s up to everyone to understand their own hazards – these are much easier to identify then to understand or quantify the risk of a hazard.
A risk is the chance, high or low, that any hazard will actually cause somebody harm. This is an area that will also differ for each reader – as I don’t have a precise map of each readers risk.
Difference in use:
Understanding potential hazards to your life or business is important. This will help you prevent losses and accidents from occurring -with appropriate risk management or loss prevention techniques.
However, knowing the risk associated with a loss is critical to implementing a loss prevention or risk management technique.
Using the words carefully is equally important for the novice and experienced insurance pro.
Lottery example
An extreme example I would use to highlight the difference between the two, is the risk of a key employee retiring due to winning the lottery.
The hazard is the key employee retiring. (This specific example is using lottery as an example, but retiring for any reason would be a similar thought process).
Most people know the chance of winning the lottery are low (around 1 in 292,000,000 but I’m sure expectations of wining are much better!) – most people say they would retire if they won the lottery (depending on size of the jackpot) but lets say 90% chance of retiring so in this simple example the risk of the employee retiring due to winning the lottery is 1/292m x .90 = risk of employee retiring due to winning lottery.
So this is an estimate of the risk, I chose an low risk example to highlight the difference between the two. However, some companies and individuals use this same economic expected value calculation to determine their own risk.
Warren Buffett and D&O Insurance
According to the annual reports of Berkshire Hathaway, which makes much of its money on insurance and investing insurance premiums, Warren Buffett’s company does not provide Directors and Officers liability insurance for its own directors.
It is been reported to be due to the culture and keeping directors aligned with owners, however, I expect the risk has been reviewed and the expected value is lower than insurance premiums and within the risk threshold of the organization.
The probability of loss x the size of the loss = expected value (risk). Then the frequency of loss must also be considered, how many losses can BRK expect each year due to D&O hazard.
Although I didn’t highlight the calculation, we could probably agree the risk is greater than the lottery example.
Considering Berkshire Hathaway size, I anticipate the balance sheet is able to retain a large amount of risk. The approach to self insure must partially be based upon the Expected Value of the risk.
My personal insurance
When it comes to my personal insurance, I use the same principles of understanding hazards and trying to quantify risk. My personal net worth is my balance sheet.
If I can’t quantify the risk or the risk is a large % of my net worth, I look at risk transfer options (i.e. Insurance).
Otherwise, when I can quantify – it’s a personal decision around my risk threshold, risk management techniques used, and/or statutory or financial requirements to buy insurance.
Earthquake insurance as an example, as discussed previously, all areas of the globe are exposed to the hazard of earthquake. For me, living in NY, the probability of earthquake is lower than someone living on a fault line like New Madrid or San Andreas.
A couple questions I ask myself are, in the event it occurs in NY:
- how likely is it that an EQ damages my house and what would be the financial impact?
- What is the frequency of NY earthquake with strength over 4 or 5 magnitude?
- What is the replacement cost of my house?
These answers help me define my risk. Considering EQ is excluded from the standard homeowners policy, this risk would be exposed to my net-worth.
This analysis can be used for all personal risks and value of insurance products – auto, homeowners, business, life and health insurance (a quick tip – at the time of writing the article the expected probability of death is still 100% …famous quotes of “Death and Taxes”- but use the probability of death before a certain age for calculating the value of Term life insurance vs. premium.)
Conclusion
This is one area that online aggregators and tools like Mint.com and Personal Capital unfortunately fail to capture. Understanding your net-worth is vital but understanding the risk to this # is of equal importance and not captured by an aggregator easily.
Understanding Hazards vs. Risk is a critical component of InsuranceShark – and the goal is that readers will hopefully become sharks when it comes to identifying hazards, analyzing exposure, and quantifying risk.
