Finding the Risks That Could Break Your Finances

Worrying about money in general is exhausting and changes nothing. Knowing exactly which three or four events would hurt your household most, and what you have in place for each, is calming and useful. This chapter turns a vague sense of risk into a short ranked list: what you could lose, how likely and how severe each threat is, the four ways to handle a risk, and a stress test that shows whether your current setup would hold.

Start with what you could lose

A risk matters only in proportion to what it can take away. List three things:

• What you own. Savings, investments, retirement accounts, home equity, cars and valuables.
• What you owe. A mortgage, car loans, student loans and any debt someone else co-signed. Debts do not disappear when income does.
• What you will earn. Your future paychecks, which economists call human capital. For most people under fifty this is the largest item by far, and it is the one most often left uninsured.

Someone earning $6,000 a month with 25 working years ahead stands to earn $1,800,000 before any raise. That figure is not a target for insurance, and a needs analysis in chapters 4 and 5 will shrink it, but it shows why the ability to work deserves protection long before a stock portfolio does.

Rate each risk by likelihood and severity

Next, list the events that could cost you money and give each two rough scores: how likely it is over the next ten years, and how much damage it would do if it happened. You do not need precise odds; "rare, possible, likely" and "small, serious, ruinous" are enough to rank.

A starting list for most households:

• Losing the ability to work through illness or injury. The Social Security Administration estimates that roughly one in four of today's 20-year-olds will become disabled before reaching retirement age. Likelihood: possible. Severity: ruinous without coverage.
• The death of someone whose income or care others depend on. Less likely than disability during working years, but ruinous for a family without coverage.
• A large medical bill. Severity is capped by your health plan's out-of-pocket maximum, if you have a plan.
• Causing an injury in a car crash or on your property, followed by a lawsuit. Rare, but with no natural ceiling.
• Losing your home or its contents to fire, storm or flood.
• Losing your job. Likely at some point in a career, usually survivable with cash.
• Fraud and identity theft. Common; usually moderate in cost but heavy in time.

Multiply the two scores, or simply sort the list so that anything ruinous rises to the top regardless of likelihood. The top of the list is where insurance belongs.

Four ways to handle a risk

Insurance is only one tool. Risk managers use four, and a good plan mixes them.

1. Avoid it. Do not take on the exposure at all: skip the backyard trampoline, do not co-sign a loan you could not repay yourself.
2. Reduce it. Lower the odds or the damage: smoke detectors, a water-leak sensor, defensive driving, staying current with preventive care, a password manager and two-factor sign-in.
3. Transfer it. Pay someone else to carry it, mostly through insurance. Best for rare, severe losses.
4. Retain it. Keep it yourself and set money aside: higher deductibles, an emergency fund, no coverage for small breakages. Best for common, small losses.

The pattern that follows is consistent. Transfer the ruinous risks, retain the small ones, and reduce whatever you cheaply can. A household that insures everything pays heavily for coverage it never needed; one that insures nothing is one bad event away from debt.

Risks that arrive together

The most dangerous situations come in clusters, and a plan that handles each risk alone can still fail when two arrive at once.

• A job loss can take your insurance with it. Health, disability and group life coverage often end with employment. Federal COBRA rules let many people keep an employer health plan for a limited time, typically 18 months, but at up to 102% of its full cost, and disability and life coverage usually cannot be continued on the same terms.
• A recession can hit your job and your savings in the same year. If your emergency fund is invested in stocks, it may be worth least exactly when you need it.
• A serious illness can mean medical bills and lost income at once. Health insurance covers the first; only disability insurance and cash cover the second.

For each risk at the top of your list, ask what else would likely go wrong at the same time, and whether your plan covers the pair.

Stress-test your plan

A stress test asks a blunt question: if this happened next month, how long could the household keep paying its essential bills? Three scenarios cover most of what matters:

1. Income stops for six months (a layoff or a long illness).
2. A serious illness, with your health plan's out-of-pocket maximum to pay and several months off work.
3. An at-fault accident with injuries larger than your auto liability limit.

A household whose essential bills come to $4,500 a month and that holds $9,000 in cash can keep going for about 2.0 months with no income. Riding out the six-month scenario takes $27,000, so the gap is $18,000. Disability insurance would shorten that gap in the second scenario (after its waiting period), and an umbrella policy is what answers the third. Run the same test with your own numbers in the emergency fund calculator.

When to redo the map

Your risk list changes when your life does. Revisit it once a year and after any of these: marriage, divorce or a new partner; a child or another dependent; buying a home or a rental property; a large change in income; starting a business or side work; a new teenage driver; a diagnosis that affects your health or work; and approaching retirement, when the risk of outliving savings replaces the risk of losing a paycheck.