Elements of Risk Management
Vocabulary first
Risk is uncertainty about loss. Peril is the cause of loss, such as fire or windstorm. Hazard is a condition that increases the chance or severity of loss, such as an icy sidewalk or oily rags. Pure risk involves only loss or no loss and is insurable; speculative risk involves the chance of gain and is not.
The process
Identify exposures, analyze them by frequency and severity, select techniques, implement, and monitor. Questions love the sequence and the idea that monitoring closes the loop.
Techniques
Avoidance eliminates the exposure. Loss control reduces frequency (prevention) or severity (reduction). Retention keeps the risk and may be planned or unconscious, funded or unfunded. Transfer shifts the financial consequence. Insurance is a transfer, but so is a hold-harmless agreement or a lease requirement - noninsurance transfer is a frequent trap.
Selection tools
The risk management matrix plots frequency against severity. Low frequency and low severity: retain. High frequency and low severity: control and retain. Low frequency and high severity: transfer, usually through insurance. High frequency and high severity: avoid. Also know the cost of risk - premiums, retained losses, loss control spending, and administration - and the law of large numbers, which makes prediction more reliable as the number of similar exposure units grows.
Worked example: a manufacturer with one high-value warehouse in a flood plain faces low frequency but catastrophic severity, so avoidance or transfer is indicated, and the retention question becomes how large a deductible the balance sheet can absorb.