Risk Management

This is an important service that can affect your insuring costs. There is no cost to you when you have an independent insurance agent help you with this task. By Washington law, an insurance agent cannot accept payment for risk management services if they accept a commission on the premium that results from that advice.

An essential part of an MBA program is the study of Risk Management. It is a large and diverse subject covering many disciples of business, education, banking, politics and science. What we will be discussing here is what I call operational risk management. What is it? It is the analysis of risk and the methods of dealing with it.

There are many risks that we take on in everyday life, and all risks must be managed. If you are concerned with drowning because you can’t swim, then it might be a good idea to avoid being in the water. That’s an example of avoiding risk. Sometimes, however, we have to be in water that is over our heads, so we make sure that we have a flotation device, and a safe craft to be in. This is an example of managing risk.

Four Principles Dealing with Risk:

Avoidance

Loosing your investment in a home can be avoided by renting one. Adding a product to your business that may cause litigation might be best to steer clear of. Sometimes avoidance is the prudent path to follow. Too often we read about people who took on some difficult task and lost everything. Like the non-swimmer; don’t get near the water. Avoiding risks can also means losing out on the potential gain that accepting (retaining) the risk may have allowed. Some of our great joys and achievements come from taking risks. That would include getting married and having children!

Reduction

We often find it is not possible to avoid taking risks. To reduce the risk of burglary, we can install good locks and outdoor lighting, or place valuables where it makes it more difficult to find them. Here we are reducing the risk and severity of loss should there be one. This method must be carefully considered. If we install a sprinkler system in our home or business, we reduce the probability of a fire destroying our property, but we may experience a greater loss from the water damage caused by the sprinkler. In general, this method is the most practical for our homes and businesses. Redundancy is also a good method. Having more than one fire extinguisher handy can save a day. Most prudent people do this without thinking of it as risk management.

Retention

This method is accepting the loss when it occurs. True self insurance falls in this category. Risk retention is a viable strategy for small risks where the cost of insuring against the risk would be greater over time than the total losses sustained. Having a high deductible is an example of this. It often surprises people when I show them that increasing the deductible from $250 to $1,000 on the collision part of their car insurance causes a reduction in premium that exceeds what the insurance company would pay them even if they had an at-fault accident every seven years. By not insuring property for its replacement costs are another example of this method. If it were to cost $100,000 more to replace your home than you have insured it for, you are self-insuring on that portion. There are times when it is feasible to accept risk and other times when it is not. A rule that I like to use is: When you can afford to lose it, don’t insure it. If you can’t afford to lose, consider insurance.

Transfer

After first considering the first three methods of risk management, the last method is used. For small businesses and individuals, the insurance policy is the only effective way to transfer risk. Transferring risk means causing another party to accept the risk, typically by contract. This is usually an insurance policy. It may involve contract language that transfers a risk to another party without the payment of an insurance premium. Liability among construction or other contractors is very often transferred this way. Municipalities often use risk retention pools that are technically retaining the risk for the group, but spreading it over the whole group. This is different from traditional insurance, in that no premium is exchanged between members of the group up front, but instead losses are assessed to all members of the group. This has been tried with various co-ops, but has failed to become a viable option because the loss assessments cannot always be paid by the member. Tax supported institutions have us to fall back on.

This method is the only one to be used when considering the risk of lawsuits. Very few people or small businesses have enough money to defend themselves or pay judgments handed down by the courts. Some individuals have minimal limits on their liability insurance. What they are doing, in effect, is having an insurance company take the risk of the smaller litigations, and they are assuming the larger ones.

Generally, Risk Management is the process of measuring, or assessing risk and then developing strategies to manage the risk. In general, the strategies employed include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk. Traditional risk management, which is discussed here, focuses on risks stemming from physical or legal causes (e.g. natural disasters or fires, accidents, death, and lawsuits).