Because risk is the possibility of a loss, people, organizations, and society usually try to minimize or manage risk. Risk management can be subdivided into 2 broad categories: risk control, avoiding or reducing risk, and risk financing, setting enough money aside to cover losses or transfering the risk to 3rd parties, such as insurance companies. Within these categories, there are 5 major methods of handling risk:
- Risk Control
- loss control
- Risk Financing
- noninsurance transfers
Risk control is the best method of managing risk and usually the least expensive. Risk control involves avoiding the risk entirely or mitigating the risk by lowering the probability and magnitude of losses. Many risks cannot be avoided, but almost all risks can be mitigated through the use of loss control. Nonetheless, even losses from mitigated risks can be expensive, so both people and businesses usually transfer some of that risk to 3rd parties.
Risk 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. A business cannot operate without taking some risk. Virtually any activity involves some risk. Generally, risk should be avoided when losses are large and gains are small. Where avoidance is not possible or desirable, loss control is the next best thing.
Loss control (a.k.a. risk reduction) can either be effected through loss prevention, by reducing the probability of risk, or loss reduction, by minimizing the loss.
Loss prevention requires identifying the factors that increase the likelihood of a loss, then either eliminating the factors or minimizing their effect. For instance, speeding 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 accidents at slower speeds generally cause less damage. Salvage operations may also reduce the cost of the loss.
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, since it can learn from its mistakes. Businesses can control losses through either an engineering approach or behavioral approach. The engineering approach sets up both the business environment and procedures to lower the probability of losses. For instance, using robots to perform hazardous procedures eliminates the risk of having people perform those procedures. The behavioral approach recognizes that many losses are incurred because of human error or lack of training, so workers are trained to follow procedures that will lower the probability of losses or the magnitude of those losses. Monitoring the workers to ensure that they are practicing safety is another effective means of loss control.
Risk financing focuses on methods for paying for losses, which is necessary because not all losses can be prevented. Risk financing is accomplished by retaining the risk, and for some risks, some or most of the cost of potential losses is transferred to 3rd parties, usually insurance companies. Although insurance is a major means of lowering the cost of losses, all people and businesses retain risk to some extent, even for insured losses, because most forms of insurance have deductibles, and some have copayments.
Risk retention, (aka active retention, risk assumption), is handling the unavoidable or unavoided risk internally, either because insurance cannot be purchased or it is too expensive for the risk, or because it is much more cost-effective to handle the risk internally. Usually, retained risks occur with greater frequency, but have a lower 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 — what is commonly called 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 or change direction, and, in a collision, higher speeds will always result in more damage and a higher 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. Hence, speeding is a form of passive risk retention.
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, an S 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, although reinsurers may cover these types of risks by relying on statistical models to estimate the probabilities of disaster. Speculative risks — risks taken in the hope of making a profit — are also not insurable, since these risks are taken voluntarily, and, hence, are not pure risks.