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Risk Management

Risk management is the term given to the study of risk and its effects, and to the formulation of strategies to control or eliminate risk. It was developed specifically for use in organizations, but it has been found to have practical application in our everyday lives, especially in relation to insurance. Understanding the basics of risk management can help you formulate a more logical insurance program, reduce your insurance costs and reduce the frequency of claims.

Risk is the probability of occurrence of an event which causes loss, combined with the probable magnitude of the loss which it causes. For example, driving on a highway and driving in a busy parking lot might have the same probability of resulting in a crash, but driving on the highway carries a greater risk due to the greater probability that a highway crash will cause greater loss. Making a distinction between the probability of an event occurring and the magnitude of the loss which would result is fundamental to risk management and its application to insurance.

Risk and Reward

Risk Management
Key Points:

  • It is the study of risk and how to control it.
  • It can help you to manage your risks.
  • Risk = Probability of Loss x Probable Magnitude of Loss.
  • Strategies are to Avoid, Reduce or Transfer risk (ART).
  • In practice, you often combine the strategies.

The corollary of risk is reward. In fact, we only fully understand the nature of risk when we understand the nature of the relationship between risk and reward. Risk is not a bad thing in itself, but uncompensated risk is. For example, a young person saving for retirement will actively seek investment risk, because in the long run greater risk will likely result in greater returns. On the other hand, taking on risk which has no prospect of producing a payoff is something to be avoided. An example of this would be driving home drunk while a sober (and insured) passenger could just as easily have driven you home instead.

In managing risk we routinely ask these three questions:

  1. What are the chances of the adverse event occurring?
  2. What would be the size of the loss if it did?
  3. What is my expected payoff for assuming this risk?

Risk management is concerned with reducing (and sometimes avoiding) risk and its probable effects, and increasing the likely payoffs which result from taking on risk. In many ways it is the science behind the expression I took a calculated risk. We use risk management in insurance in a number of ways, such as estimating the frequency of certain types of claims based on our individual circumstances and characteristics, choosing the types and levels of coverage to include in auto insurance policies, and calculating the optimal deductibles to choose.

The ART of Risk Management

There are three fundamental strategies for managing risk, summed up in the acronym ART:

  • A  =  Avoid
  • R  =  Reduce
  • T  =  Transfer

In many everyday situations, the best approach will be to use a combination of the three strategies, and often the optimal approach will be to use a combination of non-insurance and insurance solutions. In fact, from a consumer’s perspective, non-insurance strategies for managing risk should always be the first to be considered, with insurance being used only if it results in the most effective risk and return trade-off. The reason for this is that many non-insurance solutions are either costless or less costly than transferring a risk to an insurer through payment of a premium, a premium which necessarily implies a profit margin.

Avoiding Risk

Avoiding risk means not taking it on in the first place, thereby avoiding all the consequences (potential losses and potential rewards) of the risk. It is a strategy which is followed after reaching a decision that the probability of the risk materializing, combined with the quantum of losses which would result if it did materialize, outweigh the expected benefits of assuming the risk. For example, you might decide:

  1. Not to revisit your youth by buying a motorcycle, and taking on the resulting high-cost insurance and the greater exposure to personal injury;

  2. Not to let your teen obtain a driver’s license until he can demonstrate that he is responsible enough to drive;

  3. Not to run that yellow light, which has now been on for more than a second or two, to make up for lost time.

For some risks the rewards are entirely subjective. For example, the rewards of certain risks can be confined to personal satisfaction or enjoyment, such that the extent of the reward in relation to the risk is wholly dependent on the characteristics of the individual (as in one man’s meat is another man’s poison). While the rewards can be great for some, for others the fear of the risks can partially or completely negate the expected rewards. For this reason some people would never go hang gliding, bull riding or rock climbing, for example.

Reducing Risk

Reducing risk means takings actions that either (1) reduce the probability of the adverse event occurring at all, (2) reduce the probable severity of the loss if it does occur, or (3) a combination of these two. In principle, one should always try to minimize risks and maximize the rewards which derive from exposure to those risks, subject to the costs incurred in doing so in relation to the potential losses and rewards. Common examples of risk reduction are:

  1. Servicing your car regularly and properly, particularly in regard to safety items such as tires, brakes, lights and steering;

  2. Replacing your car with one which has modern safety features such as computer-aided brakes, multiple air bags and high safety ratings in crash tests;

  3. Driving your car at times and in places which reduce the probability of crashes occurring, and in ways which reduce the incidence of distractions (such as cell phones).

Major factors which appreciably increase the risk of road crashes are alcohol, drugs and speeding. For example, a driver’s risk of having a crash increases in direct proportion to the number of times the driver has been cited for speed violations in the past (Advisory No. 23, The Insurance Institute for Highway Safety). In the study it was found that California drivers with no speed citations during the previous three year period had an average of 135 crashes per 1,000 drivers during the subsequent three year period, but for drivers with just one speed citation, the average crash rate was almost 50% higher. The rate was more than 100% higher for drivers with two or more speed citations during the same three year period.

Transferring Risk

Transferring risk means handing it over to another person or organization, in part or in whole, along with the potential losses and potential rewards that go (partly or wholly) with it. Risk can be transferred to a party which is in business for that very purpose (an insurance company) or to any other party legally capable of assuming risk. The more prevalent of the two is a transfer of risk to an insurance company, but people are often not aware just how common risk transfer through other means is. For example, whenever you sign a contract to rent an apartment, a car, a boat or an RV, or sign a contract to purchase a home or a car, or apply for a credit card, or even rent a power tool, risk is transferred from the other party to you.

If you take the time to read the small print before scribbling your signature at the bottom of the contract, the extent to which risk can be transferred to you may surprise or even shock you. Ordinarily you will assume personal liability for any injuries you cause to another person while using a rented item or while leasing premises such as an apartment or restaurant, and for any damage which you cause to the item, the premises or to any other person’s property, even if the injury or damage is not your own fault. Given that scenario, how confident are you that the standard liability coverage provided by your auto insurance or other policy will be sufficient to protect you? Unless you have umbrella insurance, any confidence you have may be misplaced.

However, the good news is that transferring risk by contract can work both ways. Here are some examples of using insurance and non-insurance transfer strategies to manage risk:

  1. You transfer the risks you face as a driver, up to certain limits, for personal liability, personal injury, uninsured and underinsured motorists, and collision and other damage to your car, to an insurance company in consideration for payment of a premium;

  2. You transfer the personal liability risk of carrying co-workers in your company-supplied car (which is not covered by your employer’s business insurance) to your employer by written agreement, even if that simply consists of an exchange of e-mails;

  3. You transfer 75% of your personal liability risks to your three buddies when you rent a $200,000 houseboat, by making sure they co-sign the rental contract with you.

Practical Risk Management

In practice, risk management often involves combining the strategies of avoiding, reducing and transferring risk. For example, buying a car which ranks well in crash tests, then taking out an auto insurance policy with a $1,000 deductible (and with single, not split limits), brings all three strategies into play. This approach is often the most cost-effective means of managing risk.

The net result after avoiding, reducing and transferring risk is your retained risk. This is the risk which you have chosen to accept, and to fund the consequences of, should the risk ever materialize. For example, retained risk might be represented by an insurance deductible, the absence of collision and comprehensive coverage, or waiving road service and rental car coverage. The important point is that whatever retained risk you have you are aware of (you will now always read contracts before you sign them), and your resources permit those risks to be accepted and managed.