Handling Risk

Because risk is the possibility of a loss, people, organizations, and society usually try to avoid risk, or, if not avoidable, then to manage it somehow. There are 5 major methods of handling risk: avoidance, loss control, retention, noninsurance transfers, and insurance.

Avoidance is the elimination of risk. You can avoid the risk of a loss in the stock market by not buying or shorting stocks; the risk of a venereal disease can be avoided by not having sex, or the risk of divorce, by not marrying; the risk of having car trouble by not having a car. Many manufacturers avoid legal risk by not manufacturing particular products.

Of course, not all risks can be avoided. Notable in this category is the risk of death. But even where it can be avoided, it is often not desirable. By avoiding risk, you may be avoiding many pleasures of life, or the potential profits that result from taking risks. Those who minimize risks by avoiding activities are usually bored with their life and don’t make much money. Virtually any activity involves some risk. Where avoidance is not possible or desirable, loss control is the next best thing.

Loss control works by either loss prevention, which involves reducing the probability of risk, or loss reduction, which minimizes the loss.

Losses can be prevented by identifying the factors that increase the likelihood of a loss, then either eliminating the factor or minimizing its effect. For instance, speed and driving drunk greatly increase auto accidents. Not driving after drinking alcohol is a method of loss prevention that reduces the probability of an accident. Driving slower is an example of both loss prevention and loss reduction, since it both reduces the probability of an accident and, if an accident does occur, it reduces the magnitude of the losses, since slower speeds yield less damage.

Most businesses actively control losses because it is a cost-effective way to prevent losses from accidents and damage to property, and generally becomes more effective the longer the business has been operating.

Risk retention, as active retention or risk assumption, is handling the unavoidable or unavoided risk internally, either because insurance cannot be purchased for the risk, because it costs too much, or because it is much more cost-effective. Usually, retained risks occur with greater frequency, but have a low severity. An insurance deductible is a common example of risk retention to save money, since a deductible is a limited risk that can save money on insurance premiums for larger risks. Businesses actively retain many risks—self-insurance—because of the cost or unavailability of commercial insurance.

Passive risk retention is retaining risk because the risk is unknown or because the risk taker either does not know the risk or considers it a lesser risk than it actually is. For instance, smoking cigarettes can be considered a form of passive risk retention, since many people smoke without knowing the many risks of disease, and, of the risks they do know, they don’t think it will happen to them. Another example is speeding. Many people think they can handle speed, and that, therefore, there is no risk. However, there is always greater risk to speeding, since it always takes longer to stop, and, in a collision, higher speeds will always result in more damage or risk of serious injury or death, because higher speeds have greater kinetic energy that will be transferred in a collision as damage or injury. Since no driver can possibly foresee every possible event, there will be events that will happen that will be much easier to handle at slower speeds than at higher speeds. For instance, if someone fails to stop at an intersection just as you are driving through, then, at slower speeds, there is obviously a greater chance of avoiding a collision, or, if there is a collision, there will be less damage or injury than would result from a higher speed collision.

Risk can also be managed by noninsurance transfers of risk. The 3 major forms of noninsurance risk transfer is by contract, hedging, and, for business risks, by incorporating. A common way to transfer risk by contract is by purchasing the warranty extension that many retailers sell for the items that they sell. The warranty itself transfers the risk of manufacturing defects from the buyer to the manufacturer. Transfers of risk through contract is often accomplished or prevented by a hold-harmless clause, which may limit liability for the party to which the clause applies.

Hedging is a method of reducing portfolio risk or some business risks involving future transactions. Thus, the possible decline of a stock price can be hedged by buying a put for the stock. A business can hedge a foreign exchange transaction by purchasing a forward contract that guarantees the exchange rate for a future date.

Investors can reduce their liability risk in a business by forming a corporation or a limited liability company. This prevents the extension of the company’s liabilities to its investors.

Insurance is another major method that most people, businesses, and other organizations can use to transfer pure risks by paying a premium to an insurance company in exchange for a payment of a possible large loss. By using the law of large numbers, an insurance company can estimate fairly reliably the amount of loss for a given number of customers within a specific time. An insurance company can pay for losses because it pools and invests the premiums of many subscribers to pay the few who will have significant losses. Not every pure risk is insurable by private insurance companies. Events which are unpredictable and that could cause extensive damage, such as earthquakes, are not insured by private insurers. Nor are most speculative risks—risks taken in the hope of making a profit.

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Information is provided 'as is' and solely for education, not for trading purposes or professional advice.