Should you own Zombie Apocalypse Insurance?: Four risk mitigation disciplines to get familiar with
Zombie Insurance exists…yes really, if only as a marketing ploy for insurance shops. But it gives us a great reason to discuss the different types of risks, and the disciplines that exist to mitigate the given risk set.
Zombie Apocalypse Risk is both an unmitigable risk, there is little if anything you can do to avoid an apocalypse. And it’s also not cost-effective, the replacement of anything lost in the apocalypse is unlikely – the insurer after all is very likely a zombie in this scenario. So it’s an easy “don’t buy it” recommendation. But how about others’ risks? Tax, fire, disability, market, etc. all exist daily, and all have nuanced methods for handling them.
|Mitigable||Homeowners Insurance (Buy it)||Annual Downside Puts for Market Protection (likely don’t buy it)|
|Unmitigable||Life Insurance (Buy it sometimes)||Zombie Insurance (come on?!?!)|
Effective risk mitigation requires understanding both the financial risk at play and the full length of consequences that result from the strategy a person or family chooses. Tax Risk is a great topic to think about. Most investors “Accept” Tax Risk and pay their taxes at the end of each year depending on their income and gains from the year before. You bought the stock, it went up 20% forgo 5% as a cost of doing business and pay your income and gains tax on it.
Some Investors might “avoid” tax risk by using investment strategies, 401ks, IRA’s, or other legal means of tax avoidance. Further, still, some may limit their tax exposure by using several different investment strategies and holding strategies by spreading out the tax risk over time or using income streams that are taxed in different ways. Further still, some may use tax risk transference through trusts, gifting, and other asset location strategies to manage it.
Tax risk is just one flavor of risk, but almost every conceivable risk can be filtered through the strategies below to make the existence of risk far more tolerable.
There are several risks you “accept” every day regardless of the calculus. The risk of an airplane part striking you at a wedding is really low, so you simply accept that risk and head outside.
The risk of a single down month in the stock market is high, and so is the cost to insure against it. Risk acceptance as a strategy is about balancing the likelihood of that risk happening, the financial impact it would have, and properly pricing the below strategies to handle the risk. Risk acceptance does not reduce any effects however it is still considered a strategy.
The “acceptance” strategy is a common option when the cost of other risk management options such as avoidance or limitation may outweigh the cost of the risk itself. A company that doesn’t want to spend a lot of money on avoiding risks that do not have a high possibility of occurring will use the risk acceptance strategy.
Traditionally, risk acceptance can be the key to investment upside. The performance of the S&P 500 is a great example. If you simply accept the risk you will have more up years than down years, and the result will be net returns of about 9% year over year. If you used financial products to mitigate the financial consequence of a down year, it could cost you between 8-10% of the return to fully inoculate the risk. Leaving you with little to no return. So there are several times where risk acceptance is the more rewarding outcome.
The risk management effort is a process to target and control the damages and financial consequences of threatening events, risk avoidance seeks to avoid compromising events entirely. This is equally an activity you likely engage in regularly. You, like me, may not attempt amateur base jumping daily for a myriad of reasons. This simple act of not participating is a risk management strategy.
When determining how you will approach risk, it’s important to not confuse the strategies of risk avoidance and risk acceptance with a very different concept “risk ignorance.” Risk ignorance stems from two very different but connected problems. The first is a knowledge gap, this is a problem with risk-takers’ understanding of a market, investment, process, etc. where they simply don’t have the skill set required to uncover and handicap all of the potential risks. When I don’t work on the inner workings of my vehicle it’s an acknowledgment of that knowledge gap.
The second gap, and likely harder to uncover, is a competency gap. This is the knowledge that the risk exists, but poor reconciliation of an investor or person’s skill to overcome the difficulties. Think about new building construction. The builder might know that the risk of financing can fall through, so they have crossed the knowledge gap, but if a project still falls through because of a lack of coordination, effort, or something else entirely it fell victim to mispricing of the competency gap.
Risk avoidance is one of the least understood methods used by investors and as a result drives two negative behaviors. Rationalization or compartmentalization. In this first, investors fall in love with an idea, stated returns, or a story and begin down a path they believe is “risk avoidance” but is actually rationalizing them into risk ignorance. The second “compartmentalization” is a form of risk avoidance but for the wrong reasons. An investor may not understand a product or service and as a result, shut down a whole category of strategies. A great example is in derivatives, many people attribute the financial crises to derivative products and thus write off the whole group regardless of other tactics that might support their goals.
A lack of sophistication and understanding of risk is a common source of aversion, failure to change advisors, or even seek investment advice in the first place.
Risk limitation is the most common strategy. It is actually the core of the diversification concept and controlled usually through your investment policies. Limiting the total damage a single risk might have on a portfolio. A fantastic example would be a neighborhood a builder might see new potential in. While a single project might fit the companies needs for return and the risk might be reasonable for the reward, owning an entire investment portfolio in that neighborhood might represent compounding risks.
Within the idea of risk limitation, it is important to remember that some risks have a linear impact on the negative consequences of a portfolio. Let’s use the above neighborhood builder as an example. If there is a 1% chance that a fire wipes out a city block that you have 3 buildings on, there is then a 1% chance that the entire portfolio will be impaired as the result of a single catastrophe. By limiting the total exposure to say 1 building per city block that builder has all but guaranteed that the whole portfolio cannot be impaired simultaneously.
If through policy or practices you limit exposures along the geographic, market, and stylistic categories that exist in investments to mitigate some of your exposure to an investment. Sometimes this comes at the cost of total return, but most investors find that acceptable returns with lower catastrophic risk exposure are with the trade-off. In the above example, building across the 3 neighborhoods lowers the portfolio return from 10% (had you only built in the most lucrative) to 9% but lowers the fire risk wiping out the portfolio from 1:100 to 1:100,000,000.
Risk transference is done through changes in people, policy, the process to a willing or unwilling third party. Usually done in the financial world through insurance. But in some companies, it looks like outsourcing certain operations such as investment selection, customer service, payroll services, etc. This can be beneficial for an investor if a transferred risk is not a core competency of that investor. It can also be used so a person might focus their energy and time on more lucrative endeavors. A real estate agent might find that they can routinely guide investors and families through the process for real estate prospecting, but might inherit a Honus Wagner rookie card and find that the marketplace is different enough that the pricing expertise cannot possibly translate.
Risk transference is most commonly in the form of insurance. Buying a year of home insurance for the replacement of your house is less costly than keeping the replacement value in cash for the year. So because investors have a risk they chose not to accept (or are required by law or lender) they place the risk with the insurer, and this frees up the capital to find more lucrative returns elsewhere. And in many cases, a person doesn’t have the replacement cost on hand.
Risk transference requires balancing the financial risk at stake, and the cost of the transfer (i.e. the price of insurance). This is often done by amateur risk managers by simply “Buying” the insurance policy they are sold. This process usually doesn’t bother handicapping the other options available, nor does that effectively manage the changes to the risk and cost after the policy is signed.
Two easy way to see this failure in risk management is in insurance. A homeowners policy can lose effectiveness over time as the underlying assets and their replacement value change. This can be as simple as the rising costs of rebuilding a home. Traditionally, a homeowner’s policy declines in its efficiency as a risk mitigator with every dollar the house appreciates.
Inversely, a life insurance policy becomes overpriced with every day that goes by. If a worker is trying to inoculate against the loss of 10 years of $100k income it might be a $1 million policy on day one, and let’s say carries a premium of $1000. Giving it a risk efficiency ratio of 1:1000. But at the end of year 1 if the policy stays the same the worker only needs to inoculate 9 years of risk of no income. The worker is still paying for $1 million in coverage but only needs $900,000. In this case, they are still paying for the insurance that covered year 1, but that income was realized. Their risk has diminished, but the price they are paying has stayed the same.