We All Live With Risk
Every day, we face risks:
Car accidents.
Job loss.
Sudden health issues.
Market crashes.
Family emergencies.
Sure, we’re often told to “stay positive” or “adjust our mindset,” and that’s important for mental health—but positive thinking doesn’t eliminate real-world risk.
What actually protects you in a risky situation is preparation.
And that preparation needs to happen before the risk shows up.
After the 2008–09 crisis, I knew people who had to cancel their retirement plans. They weren’t unskilled or lazy—they just weren’t ready for a deep shock. Preparation isn’t just smart—it’s essential.
Society Is Built Around Managing Risk
Look closely and you’ll see that much of modern society revolves around understanding and managing risk:
- Car companies track accident rates by model.
- Engineers design vehicles to reduce crash injuries.
- Rocket firms work endlessly to raise recovery success from 50% to 90%.
- Insurance companies employ teams of actuaries to price health or car risks.
- Corporate finance teams project depreciation and plan for equipment failures.
- Investment managers monitor systemic risks and decide when to hedge.
In short, managing risk is what keeps modern systems running.
Without insurance, global trade and exploration might never have happened.
One of my favorite books, Against the Gods: The Remarkable Story of Risk, tells this story brilliantly.
Ordinary People Price Risk Too—Without Realizing It
You might think risk pricing is only for big institutions.
But actually, you’re doing it too.
Ever compare car insurance quotes online?
That’s risk pricing.
For the same car, driver, and coverage, one company might quote $1,300, another $1,800. Why?
Because they each assess your risk profile differently. They use their own data models to estimate:
- How likely you are to file a claim
- How big that claim might be
- And then they add overhead, profit margins, etc.
So yes—they’re seeing different versions of you.
How Risk Is Priced: Two Key Ideas
Behind every insurance quote (and most risk decisions) are just two core concepts:
- Probability – What’s the chance something bad happens?
(New driver? High-risk area? History of claims?) - Consequences – If it does happen, how bad is it?
(Minor scratch or total car wreck?)
At its simplest, insurance pricing is:
Expected Cost = Probability × Average Loss
But real-world risks aren’t just black-and-white.
They vary by severity—mild, moderate, extreme.
So actuaries and analysts use a more precise tool: an integral:
Risk Cost = ∫ [Loss(x) × Probability(x)] dx
(In plain English: add up all possible losses, each weighted by how likely they are.)
This approach doesn’t just apply to insurance. It’s used in:
- Financial markets
- Medical decisions
- Cybersecurity
- Even personal choices, like moving cities or switching jobs
In Finance, Risk Gets Priced with Options
In the markets, this process becomes very concrete.
We price risk using options.
Options are simply contracts that give us a way to transfer or hedge risk—if we’re smart about how we use them.
That’s where we’ll go next in this series.