Understanding Risk Management And The Role Of Life Insurance

Risk management involves identifying and evaluating risks and devising a method to mitigate them. The risks can either be investment or insurable. In particular, life insurance is often one of…

July 14, 2022

Written by Trey Bongiovanni

Risk management involves identifying and evaluating risks and devising a method to mitigate them. The risks can either be investment or insurable. In particular, life insurance is often one of the most overlooked types of insurance. Understanding your options and how it can play into your overall plan is crucial. Keep reading to learn some key aspects of risk management, life insurance, and more!

How to Manage Investment Risks?

Before managing investment risk, you must first determine the amount of risk you can take. Consider 3 things when doing this:

  1. Determine whether you’re in a good position to take investment risk in terms of time and finances. For instance, if you intend to invest in stocks, you must be willing to wait for at least five 5 years before they can pay off well. Also, you must have enough cash flow to support you all that time of waiting. If you don’t have these two, don’t take the risk.
  2. Are you psychologically stable to take the risk, or will you constantly suffer anxiety and stress? Don’t take a risk that will distort your sleep most of the time.
  3. Do you need it or are you just taking a risk because others are taking it? Don’t risk money you’re unwilling to lose for gains that you don’t need.

After determining that you can take the risk, you can manage it through diversification and a holding period.

Diversification

If you observe life insurance companies, you’ll notice that they thoroughly apply the concept of diversification. They lower their risks by insuring as many people as possible. The same can also be used in investing and wealth management.

Having A Wide Portfolio VS. A Small Portfolio

For example, in the stock market, you can have a wide portfolio of stocks or a small portfolio. The wide one carries less risk than the small one because it has been diversified. There’s a notion that higher risk attracts higher returns. Even though this is true, the market doesn’t pay an additional return for an additional risk which could otherwise be diversified.

If you have a small portfolio of stocks, you expose yourself to an additional risk with no guaranteed additional compensation. So, diversifying is crucial. You’ll rather have small gains than huge losses. However, diversifying your stock portfolio doesn’t entirely keep you safe. The market has huge swings in terms of returns. So, you may still be exposed to more risk. In that case, you need to extend the diversification to other assets such as bonds and cash.

Different Assets Have Different Returns

Returns from stocks, cash, and bonds are not entirely correlated. Therefore, a portfolio containing all of them will have less risk than one with only stocks. However, the disadvantage of bonds and cash is that they yield low returns compared to stocks. Because of this, you can invest in real estate. It has almost the same level of returns as stocks.

Holding Period

The time dimension is another great way to mitigate risks in your stock investments. Your risks will be reduced significantly if you hold your stock investments for a longer period. However, it doesn’t mean that risk is eliminated completely. Even though the 20 years stocks have no negative cumulative return, there’s still that possibility. But the low probability gives you more confidence to hold your stock investments for a longer period.

Managing stock investment risk is different from managing bond investment risk. Two ways are applicable, including managing default risk and interest rate risk.

Managing Default Risk

U.S. Treasury securities can help you minimize default risk since they are risk-free. Other alternatives are AAA securities which are almost risk-free, and “junk” bonds which carry comprehensive default risk. However, you must know that “almost” risk-free isn’t risk-free. Therefore, if you invest in such bonds, you need to diversify them.

Managing Interest Rate Risk

The value of bonds and interest rates are inversely correlated, meaning if interest rates increase, the bond value decreases and vice versa. This then forms interest-rate risk. Bonds with a longer maturity tend to have a higher interest-rate risk than those with a short maturity.

For instance, if the interest rate increases by 1%, it may not affect a bond that matures in the next 2 days. But it will significantly affect one that will mature in 30 years. The bond could decline in value by almost 12%.

The U.S. Treasury securities are also prone to interest-rate risk. It’s only the risk of default that doesn’t apply to them. So, they can lose value if interest rates increase. The only way to mitigate this risk is by never selling your bond until it matures. Therefore, ensure that before buying a bond, its maturity is in line with the time you’ll need that money.

Importance of Life Insurance for Financial Planning and Risk Management

Life insurance is pretty crucial for wealth management and risk management. It helps you prepare for the unexpected, thereby giving your family a chance to stand up again after your demise. There are many benefits of life insurance:

  • It funds your family’s expenses, such as your children’s college education. Almost 40% of the households will experience financial strain once their breadwinners die. They will no longer be able to take care of their daily expenses. Life insurance changes this by ensuring the expenses are catered for.
  • Pays off loans such as credit cards, home mortgage, student loans, and car loans, leaving your family with no debts.
  • It ensures that your business has enough funds to continue running in your absence.
  • The benefits are tax-free, meaning there will be no tax burden on your family when collecting the money from the insurer.
  • It can be used to cover funeral expenses. The average funeral cost in the United States in 2019 was $7,640, which can be challenging for your family to raise if the insurance doesn’t chip in.
  • It funds other obligations like care for your aging parents. To ensure their care doesn’t cause great financial hardship to your family after your death, the insurer takes care of all their expenses.

Most Used Types of Life Insurance

Credit Life Insurance

Here, the insurance pays for a mortgage or any other debt the insured had by the time they die. The premiums for this life insurance are paid every month.

Term Insurance

Term insurance pays the beneficiaries only after the demise of the insured. You can buy this type of life insurance with fixed or varying premiums. The fixed premiums remain the same for the specific number of years the policy is to cover. Varying premiums can start at a lower amount and slowly increase as you grow older.

Cash Value Insurance

Also known as Whole Life Insurance, this insurance combines savings and death insurance. Unlike term insurance where the beneficiaries are paid only if the insured dies, this insurance can pay the insured while still alive. Some of the premiums are invested in building a cash value, meaning that its premiums are higher compared to term insurance premiums.

The cash value is what the insured is paid if they don’t die early. It can be paid in lump sum or as an annuity. The insured can also use this cash value as collateral to get a loan. Most importantly, it’s tax-free and can be used for estate planning. Also, cash value insurance has no age limits. It may continue even after the insured has died.

The purpose of financial planning and risk management is to ensure you achieve true wealth. Contrary to most notions, true wealth isn’t only about money. It’s also about freedom and spending your time on earth well, ensuring that you leave a legacy for your next generation. Besides, it entails having confidence in your future.

Nesso Wealth – Helping You Manage Your Risk

At Nesso Wealth, we are determined to ensure you achieve true wealth. We have several ways to help you in this:

  • We help you set your family up for success. This applies especially to young people who are starting and looking to expand their income, pay off their debts, and grow wealth.
  • We assist you in accumulating wealth and pursuing goals. After you gather some money, you’ll need it to grow. You can do this by following a simple investment plan that we provide.
  • Prepare for your retirement and beyond. You’ll need enough funds to take care of your needs after you retire, and we can also help you through this.
  • We support you in making the most of retirement. It applies when you want to protect your legacy so that you don’t go broke after retiring.

To ensure that nothing prevents you from achieving your goals, we offer coaching lessons on important aspects of your life. We’re also your accountability partner to ensure that you follow through with your plan since planning is never enough without executing the plan.

We will be there when you decide and when you experience challenges to make the journey worthwhile. We will communicate what should be adjusted to correct the mistakes made along the way and ways to avoid them in the future. Therefore, if you need to achieve true wealth, don’t hesitate to contact Nesso Wealth.

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