Module – II
RISK AVERSION & MANAGEMENT TECHNIQUES
Select Appropriate Risk Management Technique/Strategies
• Once the risks have been identified and ranked as previously outlined, then the selection and application of strategies can
be completed. Usually, various combinations of strategies will work together to address the identified risks, and it is not
unusual to shift to other strategies as new risks become apparent (see Monitoring), or more information accumulates on the
risk profile of an activity.
• What Is Risk Averse?
• Risk aversion is the tendency to avoid risk and have a low risk tolerance.
• Risk-averse investors prioritize the safety of principal over the possibility of a higher return on their money.
• They prefer liquid investments. That is, their money can be accessed when needed, regardless of market conditions at the
moment.
• Risk-averse investors generally favor municipal and corporate bonds, CDs, and savings accounts.
• Management technique
• A management technique is 'a recognised method of analysing or solving a recognised type of management problem in a
detailed, systematic way'. A management problem is any situation in which a manager has to take a management decision.
Risk Avoidance
• What is risk avoidance with an example?
• Risk avoidance is where a company assesses the possibility of risk and decided not to take part in the risky activity. An
example of risk avoidance is when a company decides not to venture into producing a product that may pollute the
environment to avoid harming the environment, the possible lawsuits, and the costs involved in cleaning up the pollution.
• Avoid the risk or the circumstances which may lead to losses in another way.
• includes not performing an activity that could carry risk.
• avoiding risks also means losing out on the potential gain that accepting (retaining) the risk may have allowed.
• Not entering a business to avoid the risk of loss also avoids the possibility of earning the profits.
• How does risk avoidance fit into a risk management strategy?
• Risk management is an organizational practice that begins with the following three steps:
1. Identify threats to the organization as a whole, as well as its assets, capital, earnings and revenue.
2. Assess the probability of those risks negatively impacting the organization.
3. Quantify the damages that could be done by potential risks -- i.e., calculate their risk exposure.
What are the pros and cons of risk
avoidance?
• Like all risk mitigation strategies, the decision to avoid risk has benefits and drawbacks.
• The pros and cons of a risk avoidance strategy include the following:
• Pros
• completely or nearly eliminates a risk that has the potential to damage the organization; and
• instills confidence that the organization will continue to operate because, with the risk eliminated, it won't have to
plan for or contend with the negative consequences associated with the risk.
• Cons
• slows operations as employees, business partners and sometimes even customers adhere to the rules
implemented to eliminate the risks; and
• limits opportunities such as increasing sales, cultivating new customers and developing new revenue streams.
• For instance, the investors who opt for a savings account do indeed avoid all risk of losing their
capital value but will also miss out on growing those assets more significantly by avoiding the risk
associated with the stock market.
Or take the retailer that decides against keeping consumer data: It eliminated the risk of running
afoul of data regulations, but at the same time, it likely drastically limited its ability to create a
personalized shopping experience that could help boost sales.
Loss control(risk management technique)
• Loss control is a risk management technique
• It seeks to reduce the possibility that a loss will occur and reduce the severity of those that do occur. A loss control program
should help policyholders reduce claims, and insurance companies reduce losses through safety and risk management
information and services.
• The goal is to identify and reduce potential risk factors in a company's operations, such as technical and non-technical
aspects of the business, financial policies and other issues that may affect the well-being of the firm.
• How Can Companies Identify Emerging Risks?
Emerging risks can be challenging to identify, as they often involve novel or rapidly changing situations. Companies can
employ various strategies to detect and monitor emerging risks, such as:
• Keeping up-to-date on industry trends, news, and research to identify potential risks on the horizon.
• Engaging in scenario planning to consider possible future developments and their implications for the organization.
• Encouraging a culture of open communication and collaboration, enabling employees to share insights and concerns about
potential risks.
• Establishing a dedicated risk management team responsible for monitoring and responding to emerging risks.
Can a Company Eliminate All of Its Risks Through Loss Control?
No, it is not possible to eliminate all risks completely. Risk control aims to
minimize and manage risks, but it cannot remove them entirely. Some risks are
inherent in the business environment or the nature of the industry, while others
may arise from unforeseen circumstances. The goal of risk control is to reduce
the likelihood and potential impact of risks on the organization, helping to build
resilience and maintain stability in the face of uncertainty.
Risk-retention
• Risk retention implies that the losses arising due to a risk exposure shall be retained or assumed by the party or the
organization..
• Self-insurance and Captive insurance are the two methods of retention.
• A ‘captive insurer’ is generally defined as an insurance company that is wholly owned and controlled by its insured’s;
• its primary purpose is to insure the risks of its owners, and its insured’s benefit from the captive insurer's underwriting
profits.
• Which Risks can be Retained?
• There are a lot of risks present in the environment and you cannot cover everything with a life insurance. Thus it becomes
natural that some risks have to be retained. But how to decide the risks that can be retained? Check the following points.
• 1. If the cost of the risk is lower than the cost of insurance (cr<ci)
• 2. If the insurance policy itself does not cover a risk
• 3. If you have a large emergency fund that can be used to absorb the losses
Which type of risk can be retented
When a company chooses or is forced to retain a certain risk, they will be responsible for paying any losses from that risk
out of pocket. For this reason, it is important for companies to make sure that they can properly afford to pay for potential
losses before they make the decision to retain particular risks.
Oftentimes, the money can come from their current cash flows, from reserve funds set aside for these types of losses, or if
they are frequent and predictable enough, they can be put into the monthly budget.
Risk retention can either be done voluntarily or be forced.
The decision to retain a risk voluntarily usually comes down to an economic calculation. If the losses happen often enough
to be budgeted for or if the premiums for insuring against this risk is too high, many companies will choose to voluntarily
retain the risk. Large organizations such as railway operators or government bodies may also choose to forgo insurance and
retain almost all of their risk because they are big enough to absorb potential losses. These types of organizations can save
money by not purchasing insurance.
Other times, companies are forced to retain a risk or loss. This happens when the risk is either excluded from their coverage,
uninsurable, or when the value of the loss is less than their policy deductible.
Risk transfer
• It means that the expected party transfers whole or part of the losses consequential to risk exposure to another party for a
cost. The insurance contracts fundamentally involve risk transfers. Apart from the insurance device, there are certain other
techniques by which the risk may be transferred.
• Risk transfer refers to a risk management technique in which risk is transferred to a third party. In other words, risk transfer
involves one party assuming the liabilities of another party. Purchasing insurance is a common example of transferring risk
from an individual or entity to an insurance company.
• How It Works
• Risk transfer is a common risk management technique where the potential loss from an adverse outcome faced by an
individual or entity is shifted to a third party. To compensate the third party for bearing the risk, the individual or entity will
generally provide the third party with periodic payments.
• The most common example of risk transfer is insurance. When an individual or entity purchases insurance, they are
insuring against financial risks. For example, an individual who purchases car insurance is acquiring financial protection
against physical damage or bodily harm that can result from traffic incidents.
• As such, the individual is shifting the risk of having to incur significant financial losses from a traffic incident to
an insurance company. In exchange for bearing such risks, the insurance company will typically require periodic payments
from the individual.
Methods of Risk Transfer
• There are two common methods of transferring risk:
• 1. Insurance policy
• As outlined above, purchasing insurance is a common method of transferring risk. When an individual or entity is
purchasing insurance, they are shifting financial risks to the insurance company. Insurance companies typically charge a fee
– an insurance premium – for accepting such risks.
• 2. Indemnification clause in contracts
• Contracts can also be used to help an individual or entity transfer risk. Contracts can include an indemnification clause – a
clause that ensures potential losses will be compensated by the opposing party. In simplest terms, an indemnification clause
is a clause in which the parties involved in the contract commit to compensating each other for any harm, liability, or loss
arising out of the contract.
• For example, consider a client that signs a contract with an indemnification clause. The indemnification clause states that
the contract writer will indemnify the client against copyright claims. As such, if the client receives a copyright claim, the
contract writer would (1) be obliged to cover the costs related to defending against the copyright claim, and (2) be
responsible for copyright claim damages if the client is found liable for copyright infringement.
What Is Value of Risk (VOR)?
• Value of risk (VOR) is the financial benefit that a risk-taking activity will bring to the stakeholders of an organization.
• All activities that a company may undertake, from entering a new market to developing a new product, carry risk.
• How much depends on the type of activity and the likelihood that the company will not be able to recoup costs.
• Value of risk (VOR) requires a company to examine the various components of the cost of risk and treat them as an
investment option.
• These calculations are only as good as the data and assumptions
• Understanding Value of Risk (VOR)
• In financial theory, corporations don’t have any risk preferences, but their stakeholders do. The goal is generally to make
money without being reckless.
• Company management knows that if they put the resources available to good use, they stand a decent chance of keeping
their jobs and boosting the wealth of investors. Sitting idly means missing out on opportunities or, as some are keen to
point out, taking profits and setting fire to them. The problem is that gain seldom comes without an element of pain. Every
decision is accompanied by risk and, therefore, needs to be scrutinized carefully before pursuing.
• All activities that a company may undertake, from entering a new market to developing a new product, carry risk. How
much depends on the type of activity and the likelihood that the company will not be able to recoup costs. At the same time,
there’s also the recognition that spending money on one endeavor carries with it an opportunity cost: the potential benefits
a business misses out on when choosing one alternative over another.
• Value of Risk (VOR) Method
• Value of risk (VOR) requires a company to examine the various components of the cost of risk.
They include the actual costs for losses incurred; the cost of bonds, insurance, or reinsurance to
fund losses; the costs of mitigating the risks that could cause the company to experience a loss; and
the cost of administering a risk management and loss mitigation program.
Pooling and diversification of risk
• Pooling arrangement means sharing loss and risks equally or split evenly any accident costs. As a result pooling
arrangements reduce risks (standard deviation) for each participant. In pooling arrangements the average loss is paid by
each person.
• The probability distribution of accident costs facing each person is reduced by pooling arrangements. The pooling
arrangement decreases the probabilities of the extreme outcomes. In pooling arrangements each person’s risk is reduced but
each person’s expected accident cost is unchanged.
• The pooling arrangement reduces risks through diversification. In pooling arrangements, the cost has become more
predictable. Normally the average loss is much more predictable than each individual’s loss.
• Pooling arrangement also decreases the additional risks by adding people. By adding more people the probability
distribution of each person accident cost will continue to be changed. In all the factors being held constant the risk that can
be reduced through pooling arrangement increases as the number of participant’s increases. In this case the pooling
arrangement decreases risk for each participant. The probability distribution would become more and more bell shaped if
more participants are added.
