Question

a. Identify and explain the major risk management approaches that are being applied in our daily life. Please provide an example for each approach you identified.

b. Rico has a comprehensive health care insurance policy with a $500 deductible per case and 80-20 with a maximum $1,500 copayment cap per calendar year. In March, Rico has a $1,200 claim. Rico experienced another claim in September resulting in a total bill of $9,000.

i. How much the insurance company needs to pay to Rico for the first claim incurred in March?

ii. How much is the total payment that Rico needs to pay for the second claim incurred in September?

Answer 1

There are three major risk management approaches that are used in everyday lives. They are :

Avoidance of Risk

Risk avoidance is the opposite of risk acceptance. It is the refusal to take any form of risk and thereby avoid potential losses. It is usually the costliest method as it involves financial losses or foregoing higher earning opportunity. For e.g.: a person might avoid investing money and keep it in a lock box. This will certainly help to prevent financial losses but it does result in foregone earnings and could also be a case of negative earnings in real terms due to inflation costs.

Transfer of Risk

This is the most commonly used for of risk management in our lives. It involves shifting the risk away to another party. Risk transfer typically takes place by paying a premium to an insurance company in exchange for protection against substantial financial loss. It is a flexible form of risk management but requires payment upfront. For example, health insurance is taken to ensure unforeseen risk from health complications. Similarly, other forms of insurance like motor vehicle, property, etc. are available which help transfer risk.

Risk Acceptance

It can be done through acceptance of risk. This is suitable when large amount of free reserves is available in the form of cash or readily available funds. When the risk can be managed through the resources in hand this is a good method of risk management. However, this is most commonly used when potential risk is less than the cost of transferring it. For example: a person might be willing to accept risk of medical expenses by keeping reserves for unforeseen events. This will require sufficient funds in hand to meet the situation. Similarly, one might not make any investment for the future education expense of their children. This is a case of risk acceptance where the entire cost will have to be borne out of the pocket at that point of time.