Financial Contingency PlanningSee also: Planning For Retirement
Disasters, accidents and unforeseen events happen everywhere in the world, and anyone can be affected. Few people would have predicted a global pandemic—and even those that did expected it to be influenza-based, rather than a completely new virus. The last few years have taught us all that it may be wise to look ahead and take some precautions to protect yourself against chance events of different kinds.
This page discusses the concept of financial contingency planning. This is the process of planning ahead to ensure that you have tried to manage potential financial risks arising from events like losing your job or changes in your circumstances. The page considers the process of planning, and the three main ways to manage these risks: saving, borrowing and insurance.
Financial Contingency Planning in Business
Financial contingency planning means planning ahead to manage the risks arising from events like natural disasters, pandemics or issues that cause changes in your circumstances.
It is a concept that is more often seen in the business context. However, it is equally important to plan ahead to protect yourself personally, especially if you have a family that is relying on you.
There are three main ways that businesses protect themselves from potential problems:
They build up reserves of cash so that they have something to fall back on when they need it;
They negotiate access to credit at favourable rates, so that they can borrow money if necessary; and
They take out insurance policies that will pay out if particular events happen, such as a fire or a flood.
The same principles apply in personal financial contingency planning: you can save, borrow or take out insurance. You might even do more than one of these.
Know Your Situation
The first step in financial contingency planning is to know your current situation.
If you have not already done so, it is good idea to go through the steps required to create a weekly or monthly budget, so that you know how much money you need in a period. You should also know how much money you have coming in, and from what sources.
There is more about how to do this in our page on Budgeting.
Saving for contingencies
The general recommendation for a contingency fund is that it should be between three and six months’ income.
This is enough to give you enough time to find a new job, if you lose yours, or to recover from a serious illness. This also means that if you have to spend from your contingency fund in an emergency (for example, if your car breaks down, or your boiler stops working and you need a new one), you should replace the money in your contingency fund as a priority.
Your first step is therefore to start saving.
If you are fortunate, you may already have more money coming in than going out. If so, you can simply channel some of the excess each month into a savings account. This will be the start of your contingency fund.
TOP TIP! Create a new account for your contingency fund
It is a good idea to create a new account for your contingency fund. That way, it is completely separate from any kind of discretionary spending account—and you know you can’t touch it unless you really, really need it.
It is also helpful to keep an eye on interest rates and move your contingency fund around periodically to different accounts or institutions to get the best rate of interest. If possible, take advantage of tax-free savings accounts.
However, don’t be tempted to lock your contingency fund into a long-term savings plan. Make sure that you always have immediate access to your money. The only exception is if you have a good line of credit that could fill the gap until you can get at your funds. In that case, you may prefer to gain a higher interest rate by choosing an account with a notice period, though probably no more than 30 days.
If money is already tight, you may need to take other action to build your contingency fund. There are two main ways that you can do that: spending less money, and earning more money.
Our page on Reducing Your Outgoings / Spending Less provides some ways that you can make a few savings on your lifestyle. Your savings can be targeted into your contingency fund until it reaches the required level.
However, you may prefer to build up your contingency fund more quickly. If so, it might be a good idea to take a second job, or create a ‘side hustle’. Options include buying and selling via eBay or other online platforms, joining the ‘gig economy’ in your spare time, or becoming an affiliate marketer. Provided you have enough money coming in from other sources to meet your main needs, you can put all the earnings from your ‘side hustle’ into your contingency fund. This should build it up faster, and mean that you can stop your ‘side hustle’ sooner—if you want to do so.
There are more suggestions in our page on Making More Money.
Access to Credit
The second option for contingency planning is to ensure that you have access to a good line of credit: the ability to borrow money at relatively cheap rates.
This might include, for example, an arranged overdraft facility (which is usually cheaper than an unauthorised/unplanned overdraft), a credit card with a low introductory rate of interest, or a personal loan.
This is probably best thought of as a second-best to having savings to tide you over, or a short-term alternative until you can access your savings.
It is also a reasonable way to protect yourself while you are building up your savings.
The first step here is to check out and build up your credit rating. A good credit rating will give you the best chance of getting a loan at a good rate.
There is more about how to do this in our page on Understanding and Improving Your Credit Rating.
WARNING! Don’t get caught out by interest rate rises
It is easy to become complacent about borrowing when interest rates are low, as they have been for some time now.
However, as inflation rises, it is likely that interest rates will also rise. Make sure that you have the ability to meet the costs of servicing and paying back your loan, even if the cost of borrowing rises.
As well as your credit rating, it is also a good idea to build a relationship with a bank or other financial institution. It is much easier to get credit if you have been banking with one organisation for a while, and have a good reputation with them.
Taking Out Insurance
The final option to protect yourself is to take out insurance.
There are many different types of insurance available, and you will need to consider which ones might be useful to you.
You will also need to balance the cost of paying for policies against the likelihood that you will have to use them.
Risk vs. reward?
Insurance is a risk game.
When you take out insurance, you are paying the insurance company to take on your risk.
However, insurance companies are careful. They don’t want to lose money.
They therefore balance the likelihood of the risk, and the cost of paying out, against the premium. If they judge that the event is likely to happen and/or that it will be very expensive if it does, then the premium will be high. The cost is also higher if the group that is pooling the risk is smaller.
In some cases, the higher premium may be worthwhile for you. You may judge that the chance of having to make a big payment that you can’t really afford is worth the cost.
However, you may also conclude that the likelihood of the risk happening, compared with the cost of the premium, means that you would be better off saving the money into your contingency fund.
It really is a balance between risk and reward.
Some types of insurance are more of a ‘no-brainer’ than others. For example, most pet owners have insurance that will pay the costs of any veterinary treatment needed, because they know that this treatment is expensive. However, the chances of needing a lot of treatment are relatively low, so the premiums are also quite low. Healthcare insurance is also often considered worthwhile, because the large group for risk-pooling means that premiums are low compared with the cost of treatment.
There are two other types of insurance that may be worth considering:
This is relatively cheap, especially when you are young (because statistically speaking, not many people die within the span of their policies). However, the financial impact of your death on your family could be devastating, especially if you are the main breadwinner.
It is therefore worth taking out a specific life insurance policy to cover the cost of your mortgage and/or any other large loans. This means that your spouse or partner (or children) will have these loans paid in the event of your death—and will therefore have one less thing to worry about.
Income protection insurance
This is designed to pay you an income in the event that you cannot work, for example, if you are ill for a long period. This is worth considering particularly if you are the main breadwinner, or if you have no other sources of income, including state benefits. However, some pensions or workplace benefits also offer this protection, so check that before paying your premium. Some policies also only apply if you are employed, not self-employed.
WARNING! Check the Exclusions on Your Policy
ALWAYS CHECK THE EXCLUSIONS ON YOUR POLICY!
This will ensure that it is actually going to be useful to you.
For example, many businesses had insurance against a pandemic before COVID-19 appeared. However, they often found that they were not protected against a new virus, only existing ones such as influenza and SARS.
It is always worth asking if the wording can be amended to meet your circumstances. It might increase your premium—but this might be worthwhile in the end.
A Final Thought
It is not pleasant to think that something might happen to you or those you love that might affect your financial circumstances.
However, accidents, natural disasters and job losses happen to people every day. It is worth taking time to plan ahead and ensure that you will be financially safe if something does happen to you. It could save a lot of trouble in the long term.