The Risk Management Matrix™

There are essentially four categories of risk that you should be aware of, each of which has a different way to handle it.  For the purpose of this article we need a short explanation of risk management and The Risk Management Matrix™.  There are only three options for dealing with risk, you can try to avoid it, you can transfer it to someone else, or you can retain it for yourself.  That’s it.  In The Risk Management Matrix™ below you see four boxes representing four different categories of risk.  In each box you will see two letters, an H and an L together.  The first letter represents the probability of the loss happening, and the second letter represents the cost associated with the event if it were to happen.

In the upper left box of The Risk Management Matrix™ we have HH which stands for High, High; meaning the probability of a loss occurring is high and the cost associated with the loss is also high.  An example of this type of risk would be free climbing (without ropes) a rock cliff.  The probability of a fall is very high, and the costs (certain injury, possible death) are also very high.  Obviously the best strategy to deal with this type of risk is to simply avoid it. 

In the lower left box we have HL which stands for High, Low; meaning the probability of a loss occurring is high, but the cost associated with the loss is low.  The best example for this type of risk is a lottery ticket.  Chances are extremely high that you will lose, but when you do it is only a dollar lost.  Again the best strategy for this type of risk is simply to avoid it.  Even though the cost is low, it is a waste of time and resources.

In the upper right box we have LH which stands for Low, High; meaning the probability of a loss occurring is low, but the cost associated with that loss is very high.  Most of the risks we face in life fall in this category.  Examples would be a catastrophic car accident, your house burning down, a terminal illness, dying prematurely, disability, lightning strike, natural disaster, etc.  Although all of these things do happen to people, statistically the odds are in your favor.  Most people do not get in the catastrophic car accident, most people’s houses do not burn down, most people don’t contract the terminal illness, most people live into retirement, etc.  However, if a person does suffer a loss in this category the costs associated with it are often enormous.  In general, many of the risks in this category are things outside of our control.  So what is the best strategy for dealing with this type of risk?  Transfer that risk to someone else, or in other words, buy insurance.  That is why insurance companies exist.

In the lower right box we have LL which stands for Low, Low; meaning the probability of a loss occurring is low and the cost associated with that loss is also low.  Common examples in this category would be things like a warranty or deductible.  If you buy a $50 radio and the salesman tries to sell you a warranty for it that costs $35, do you buy it?  Most people say no way!  Why?  Because the chances of the radio breaking are low, and the cost to replace the radio is only $50.  Besides, by the time it does break it will be so out of date you will want the new one anyway.   Oftentimes the best way to deal with risks in this category is to simply retain them.  If you are going to retain risk anywhere, you want to be sure it is in this category.

Now let’s apply The Risk Management Matrix™ to real life:  Suppose you raised your deductible on your car insurance from $250 to $1,000.  The risk you are taking by doing that is $750 more out of your pocket in the event you had to make a claim on your insurance.  Not a big risk.  When was the last time you had to make a claim?  Chances are good it has been quite a few years. 

With most insurance companies, if you raise your deductible you will lower your monthly premium.  Now you can take that savings in monthly premium and raise your liability limits on your car insurance from $100/300/100 (these numbers represent your maximum coverage per person/ per accident/ and for property damage) to $500/500/500, and purchase an umbrella liability policy of $1,000,000 or more. 

What have you accomplished by doing this?  You have retained an extra risk of $750 by raising your deductible (LL on the matrix).  But you have transferred $1,400,000 of risk (LH on the matrix) to the insurance company if an accident did occur.  Best of all, it cost you almost nothing to do it.

Below you will see The Risk Management Matrix™ again, this time with the best method for dealing with each category of risk:

There are many practical applications for The Risk Management Matrix™.  Applying this knowledge will dramatically increase your protection and will enhance your productivity in other areas of life.  It pays to understand risk management.

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