I was chatting with a neighbor this AM as we watched a couple of fire engines lazily circle through our neighborhood. The Fire Chief thought she had spotted smoke on radar and was checking a possible wildfire. Given climate change/ drought/ wildfires in California, we appreciated her caution. My neighbor casually mentioned that State Farm had abruptly refused to renew his homeowner's insurance policy after decades of him being a loyal customer without a claim.
What was he to do with the risk of damage to his home? In theory, he could absorb the risk. That is to say, he would not a pay a monthly or annual insurance premium but would instead save that money and hope that nothing untoward happened to his home. Given that a simple garage fire and subsequent remodel can easily run $100,000, absorbing the risk of possible damage is not a likely course of action.
He could of course avoid the risk. In this case, he would sell his home and move to a less fire-prone part of the US, a place where he could get homeowner's insurance. This again is not a likely option for him. He likes living in California and has roots and family here. At his age (late 70s), why would he want to create major upheaval in his life?
And finally, he can transfer the risk. It took quite a bit of doing but he finally found that Farmers Insurance is still offering homeowner's insurance. I did not have the heart to ask how much his new policy is compared to his old one. He is diligently paying his insurance premiums while hoping nothing happens to his house. If something does happen, he is hoping the insurance company will make him whole.
For Farmers Insurance, I suspect they are hoping to collect premiums while paying a minimal amount of claims. This is the most basic of revenue models - take in more money than you pay out. And hopefully they are not overcharging residents of California in the absence of decreased competition.
My thought here is that each risk strategy has a cost. Absorbing risk can be personally quite expensive. Avoiding risk involves time and money. And transferring risk to another party of course involves cost. This simple idea applies to the world of investing as well.
If you are presented with an investment that seems to transfer risk (ie, market ups and downs) to the investment company, rest assured there is a cost associated with this transfer. Remember, Farmers Insurance is willing to offer home insurance policies (ie, accept the transfer of risk) in return for the payment of premiums. You should ask about what the transfer of risk costs in an investment. It may be challenging to suss this out but it is helpful to have this information so you can make an educated decision.
There is no such thing as a free lunch. Managing risk involves costs/ fees/ expense. It is a matter of finding the right path for you when it comes to risk.