how can we manage risk

7/30/2019 How Can We Manage Risk

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Chapter 10


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How can we manage risk?

While risks cannot be eliminated, measures can be taken to reduce the probability and size of losscaused by risks. This process is known as risk management.Response to risk

The different methods used for management of risk can be broadly categorized into two categories:

Risk Control

Risk Financing

Risk ControlRisk Control methods are those that try to minimize the losses from risks. These can be of two types:

1. Risk Avoidance

Risk avoidance is accomplished by not engaging in the action that gives rise to risk. Avoiding risk is an

appropriate strategy for high frequency and high severity risks.

While the avoidance of risk is one method of dealing with risk, it has many negative consequences. for

example, you can avoid dying in an air crash by giving up air travel, but it also means giving up the huge

time savings and convenience that air travel offers.

2. Risk Reduction

Risk reduction is achieved through loss prevention and control. For example, the risk of fire can be

reduced by measures like installing fire extinguishing systems and sprinklers, using fire retardant materials

in construction. It is an appropriate strategy for high frequency and low severity risks.

Risk Financing

Risk financing methods are those that pay for losses that actually happen. These can be of two types:

1. Risk Retention

Risk retention is used when the risk is retained. The retention may be voluntary or involuntary. This is an

appropriate strategy for low frequency and low severity risks. For example, the risk of suffering from

common cold can be retained. As a general rule, risks that should be retained are those that lead torelatively small certain losses. The reason for retention is because there is a cost attached to transfering,

reducing or avoiding risk. It may be more cost effective to retain the risk since its frequency as well as

impact is low.

2. Risk Transfer

Risk transfer is the transfer of risk from one individual to another who is more willing to bear the risk.

Insurance is the most widely used means for reducing risk by transfer. Risk transfer is appropriate for low

frequency and high severity risks.


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Risk Management

Let us try to understand these for concepts better through some examples.

Examples

1] Vikram had a run of 7kms from home to his office. There are two routes he can take. One route is

faster, but highly dangerous. It is a main highway and has a record number of accidents. In other words,

the area is accident-prone. The second route typically takes him 15-20 mins more. Since it is an inner

city road, it has less of heavy traffic and this route is considerably safer. Which kind of risk would you

classify this as? What is the best way to deal with it?

Since his travel frequency in that route was twice a day, back and forth from home to office, in case of

any accident, the impact would be fatal, hence it can be classified as high frequency, high severity risk

and best way to deal with it is Risk avoidance.

2] Anand was earning well in his company. His friendliness was unfortunately taken as his vulnerability.

Whenever, any of his friends needed some money, they would invariably ask Anand. Anand could never

say no, and always felt that he should help someone in need. The loan was always given on a returnable

basis, but that never happened. What kind of a financial risk does it entail? How should it be handled?

This can be classified as high frequency, low severity risk hence best way to handle it would be Risk

reduction.

C] Prem was to take an official trip to USA. His wife also wanted to join him, as a personal holiday trip. His

company gave Prem an insurace cover. Should his wife also take an insurance cover? What are the risks that

could arise incase the risk cover is not taken? What is the category of risk and how should it be handled?


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The chance of his wife meeting with an accident is low, however if she does, the severity would be high

hence best way to deal with this is Risk transfer.

D] Laxman and Preet used to go and play together everyday with the other boys of the building. All of

them got together and played cricket in the nearby playground.It is quite possible that one of them gets

hurt while playing.

What is the probability and the risk of such an injury? How should such a risk be handled?

It is a case of low frequency and low severity, hence Risk retention is the best way to deal with it.

Personal Risk Management

The methods discussed above can also be applied to the financial risks to which an individual is exposed.

List of some of these events that have the potential to cause financial loss (whether through increase in

expenses or through decrease in earning potential) are given below:

Death

Disability

Major surgery or hospitalization

Illness

Liability for injuries to others

Burglary of home

Destruction of house and contents

Car accident major or minor damage to car

Professional Liability, etc.

Steps to handle Personal Management Risk:

Step 1 : List down all the risks.

Step 2 : Rate each event for severity of financial loss. Severity of financial loss can be categorized into:

a. Extremely Severe an event that is financially devastating, possibly resulting in bankruptcy.

b. Very Severe an event that has a huge financial impact that can radically change lifestyle of the

affected person.

c. Moderately Severe an event that has an uncomfortable but manageable financial impact.

d. Not Severe an event that has very little financial impact, that can be covered by emergency cash

reserves held in liquid form.

Step 3 : Rate each event for probability or frequency of occurrence. Frequency of occurrence can be

categorized into:

a. Extremely Probable/Frequent an event that is almost certain to happen, or that happens very

frequently.

b. Very Probable/Frequent an event that is quite likely to happen, or that happens often.

c. Moderately Probable/Frequent an event that could happen, or that happens infrequently.

d. Not Probable/Infrequent an event that is unlikely to happen, or that almost never happens.


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Step 4 : Plot all events into the four quadrants as per the following rules:

High frequency and High severity Risk Avoidance Quadrant

High frequency and Low severity Risk Reduction Quadrant

Low frequency and High severity Risk Transfer Quadrant

Low frequency and Low severity Risk Retention Quadrant

Step 5 : Compare the recommended methods of handling risks with the ways they are currently handled,

to identify gaps or mismatches in the current risk management strategies.

Create an action plan to plug the identified gaps. Keep in mind that:

Step 6 : The topmost priority must be given to risks that should be avoided or transferred but are being

borne. These risks can completely wreck the financial affairs of a person. Accordingly, they need to be

handled foremost. Next priority should be given to risks that should be reduced but are being currently

borne. These risks should be immediately managed by making lifestyle changes and by putting appropriate

loss control mechanisms in place. If risks that should be borne have been transferred through insurance,

the amount of insurance may be reduced or completely eliminated. The resultant cost savings should be

employed into addressing the other gaps. The most common method of risk transfer is insurance. In the

next chapter, we will discuss the relationship between risk and insurance.

Chapter Review

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