In my previous couple of blogs, I discussed the risks individuals and families face and how to protect against events that could decimate a household’s finances. Financial risk is integrally tied to an economic theory, known as “lifecycle finance,” which explains how people can improve their standard of living by making smart financial decisions during the various phases of their lives. The central concept of this theory is the distinction between human capital and financial capital.
Our last discussion focused on human capital, which is our future earning potential. This week I will look at a household’s financial capital, the amount of net assets, after paying down debt, that we have accumulated and is available to support us in the future.The difference between what we own (assets) and what we owe (debts), is a measure of our wealth known as net worth or in the vocabulary of
The difference between what we own (assets) and what we owe (debts), is a measure of our wealth known as net worth or in the vocabulary of lifecycle theorists, financial capital. Risks to financial capital abound and can come from outside and within our families.
External threats can come in the form of substantial losses to our property, primarily our homes and valuables, due to thefts, fire, and other hazards. The simple solution is homeowners insurance with sufficient coverage to rebuild your home given current costs of building materials and labor and replace its contents.
The greatest external threats, however, are from liability claims arising from property damage, or worse, personal injury, which includes bodily injury and pain and suffering to other parties. Without adequate protection, a single event can shatter even a wealthy family’s financial security. Fortunately, these are insurable risks. Adequate homeowners, auto, personal umbrella, and when warranted, professional liability insurance, is a necessity, not an option. Additionally, special riders or policies may be needed to cover specific risks such as swimming pools, water vehicles, household workers, and others.
In the next blog, the final post in my series on managing financial risks, I will address two other key areas that are often overlooked and yet have the potential to deal a severe blow to a family’s finances.