For many, the purpose of risk management is to help others create value. Some risk managers achieve this goal by purchasing insurance to finance losses; others initiate safety projects to save lives. Both solutions are but a small sample of risk management techniques. In this article, first we examine the set of risk management solutions; second, we review the pure risk management solution of prevention--arguably the most important of all our tools.
A convenient way to see the portfolio of all risk management solutions is to examine the risk management solution tree. This is a visual representation of the options available to create value. The tree also shows how the various solutions can be combined into a portfolio of solutions. In this simplified tree only the basic solutions are shown. In subsequent articles we will discuss other risk control and risk financing solutions.
Whatever the organization's goals, there will be opportunities and threats to those goals. Recall that opportunities are causes of speculative gains; threats are perils that may cause pure risk losses. For both opportunities and threats, the first decision is whether to accept or avoid the situation. Avoidance results in the organization not having the chance of any gains or losses. If a cost-benefit analysis shows the down side is just too large for the organization's risk tolerance then avoidance is a wise choice. If the situation falls within the organization's risk appetite or tolerance, however, then acceptance is the appropriate choice.
Once the subject is accepted the next decision is whether to spend scarce resources on controlling the risk or accepting the situation as it is. If the risk's probability, variance, impact and timing are all within the organization's acceptable ranges then "do not control" is the correct decision (a risk map can help in analyzing the risk's characteristics). For example, if the probability of loss is low, the standard deviation is small, the impact of a loss is small, and the duration of the loss is short, then it is prudent to accept the risk "as is" and not expending resources on controlling these four characteristics.
Frequently one of these parameters is not within the desired range. Then it is probably wise to spend scarce resources to get the parameter into that range. For example, in speculative risk management, if the probability of a gain is too low then it is a good idea to spend money on an enabling project such as advertising to increase the likelihood of the desired outcome. Likewise, if the impact of the gain is too small then spend resources on a gain enhancement project--perhaps adding profitable options to the product may enhance the desired revenues.
In contrast, in a pure risk situation, if the probability of a loss is too high, then it is prudent to spend resources on a loss prevention project. Alternatively, if the severity of loss is too great, then one should spend resources on a loss reduction project.
Finally, because of--or even despite--our best efforts at creating the desired probability, outcome and timing, the managing of risk must somehow be financed. There are three basic costs of risk to be financed: risk management administration, risk control and loss financing. Administrative costs include the overhead for running the risk management department, including salaries, rent, consulting fees and supplies. Risk control costs include promotions, advertising, prevention and reduction projects. Loss financing costs include retention and transfer programs, including insurance.
In this article, we focus on loss prevention projects. Some argue that this is the most valuable use of the risk management budget. …