Risk tolerance is a term that is often used when it comes to topics like investment portfolios and business transactions- but it has a very specific meaning as it relates to insurance. So what does risk tolerance refer to when you’re talking about insurance? What is risk tolerance, period? In insurance terms, risk is the chance something harmful or unexpected could happen, and risk tolerance is how prepared you are as a business or service professional to eat the costs associated with something harmful or unexpected happening.
While in investing, higher risk tolerance means being willing to lose money to get potentially better results, and lower risk tolerance means favoring investments that maintain the original investment, these definitions don’t apply exactly to insurance, though they are similar. Essentially, risk tolerance is the willingness of a business, organization, or individual to incur risks in order to gain a future reward. This definition can be extended to insurance by saying it can be seen as the willingness to increase deductibles or SIRS (self-insured retentions) in order to pay lower premiums, or simply attend to paying higher deductibles in the event that an event actually occurs.
How much risk a client is willing to take on as a service provider, a business, or a homeowner is another way of expressing risk tolerance. Risk tolerance also ties in to risk transfer. What kinds of deductibles are you willing to pay, and how much do you want to transfer to your insurance company? Insurance acts as a vehicle for risk transfer, along with additional measures like security. That may sound confusing, but it can be most simply expressed as shifting a pure risk from one party to another. When you purchase an insurance policy, you’re transferring the risk of specific losses as explained in your policy from yourself, the policyholder, to your insurer.
There are a variety of types of risk transfers. Let’s say you own a restaurant- a place where there are a variety of concerns, or risks, associated with spills or wet floors. By purchasing non-slip floor mats, or requiring employees to wear non-slip shoes as a part of their uniform, you’re reducing the risks associated with slips and falls. You also purchase an insurance policy with greater protections, and if for some reason you are sued, your policy dictates that your insurer handles the defense, the claim payment, and other associated costs, preventing you from paying for these things out-of-pocket. As a result, you’ve transferred the risks associated from yourself to your insurer.
In the case of professionals, or service providers, the risks are different. Accountants, realtors, engineers, marketing professionals, even fellow insurance agents face a different set of risks. They have a different set of concerns they face- including being sued for perceived poor performance or bad advice- a bit different than a slip and fall, for certain. As a service professional then, risk tolerance equates to considering how much risk they are willing to take on with respect to the work being performed, and would they rather purchase an insurance policy that transfers that risk over to the insurer protecting themselves from out-of-pocket expenses in the event that they are in a position to defend themselves against a lawsuit?
When it comes to determining what your risk tolerance is as a policyholder, there are a range of things to take into consideration. All businesses and service professionals have different specific needs. What size is your business? What kind of structure does your business have? What kinds of revenues are you dealing with, and how many employees do you have to consider? All of these factors play into the amount of risks your business faces. For example, service professionals have a broader range of concerns to analyze- what kinds of data and information they handle, what kinds of clients they do business with, and what the risks associated with those clients are, among other things. At the end of the day, potential policyholders and the insurance professionals they work with will need access to a full range of data to make the best decision for their business.
A typical service professional’s insurance package may include a bundle of policies. For example, if we use an accounting office, an insurance package may include a professional liability policy, a general liability policy, a cyber liability policy, a workers’ compensation policy, and perhaps some crime coverage. The accounting office may then look at the premiums and say, “Well, I am not comfortable spending x per year on insurance, I’d rather spend half of that.” As a result, they cut some of that coverage and choose to only take on professional liability and general liability policies. They’ve determined that they are willing to take on the risks associated with not having those additional policies.
In this example, if the accounting office experiences a cyber breach, they’re taking on the potential costs associated with that risk, and skipping that potential risk transfer. Ultimately, businesses and professionals either spend money on their insurance policies, additional risk transfers like security increases or better business practices, or they risk the costs associated with lawsuits and other fallout.
At the end of the day, potential policyholders should spend time discussing their needs, risk tolerance, and expectations with an insurance professional that can help them gather the data they need to make an informed decision about insurance. Having that discussion about what kinds of policies they need to put in place to protect themselves and their business and mitigate as many risks as possible is an important step toward peace of mind.
