Insurance risk vs Investment risk
I was watching a local show on TV not too long ago, you know the ones where they invite special guests to discuss a specific topic. This time the guest was a Managing Director of a reputable insurance company. The interview starts, the host bubbly as ever and the director is ready for his questions.
So it reaches a point where the guest introduces the topic of insurance risk. Obviously, because I am in the industry, I understand what he wants to talk about. But this is where the interview takes a U-turn. The host talks about a completely different risk, investment risk, and she carried the conversation along those lines. PLOT. LOST.
This is where I knew that she did not know anything about insurance risk.
Let us be honest, when most of us hear about RISK in a financial context, where does your mind go? Usually investments, right?
There definitely is a difference between investment risk and insurance risk.
First, what exactly is risk? Risk is simply the possibility of loss.
1. Insurance Risk
This is what we call pure risk i.e. absolute risk. There are no opportunities for gain or profit when pure risk is involved. Pure risk is generally prevalent in situations such as natural disasters, fires, illnesses, accidents, or death. This risk has NO RETURN, you don’t gain anything. In short, if this risk were to fall on you, you are in big trouble. This is why you should get insurance so as to restore you back to where you were before disaster struck you. Insurance does not profit you in any way, it just indemnifies (takes you back to the position you were before the unfortunate circumstance happened).
For example, if you have a car, your risk can be possibly getting into an accident. If your car gets hit, the insurance company will pay the damages (after assessment of how much damage was done to the car in monetary terms) and compensate you accordingly. This is to take you in the position you were in before the accident happened.
In the case you have a family that you provide for, the risk could be your unexpected death. This is because your family has lost your potential future income due to your early demise. In this case, unlike the car, your life cannot be restored. But if you have adequate life insurance, it can restore your economic value to your family.
This risk can also affect investments in that if you do not have a proper protection plan in
place, you might have to dip into your investments prematurely. Therefore make sure that you have adequate insurance cover and emergency savings before investing.
2. Investment Risk:
This is a risk that is associated with an investment. Risk is any uncertainty with respect to your investments that has the potential to negatively affect your financial welfare.
unlike insurance risk which is a pure risk, investment risk is a speculative risk. i.e. you can either gain or lose as a result of the choice of investment that you make. The level of risk associated with a particular investment or asset class typically correlates with the level of return the investment might achieve.
The rationale behind this relationship is that investors willing to take on risky investments and potentially lose money should be rewarded for their risk. In the context of investing, the reward is the possibility of higher returns. These investments include: venturing into a business, buying stock, bonds, real estate, oil trading, forex trading, bitcoin etc.
The tradeoff is that with this higher return comes greater risk: as an asset class, stocks are riskier than corporate bonds and corporate bonds are riskier than Treasury bonds or bank savings products.
This risk can be managed by diversifying your investment portfolio i.e. not putting all your investment eggs in one basket.
In conclusion, everything we do in life contains an element of risk.