Insurance Concepts - Part 2 - Risk Management

What's a Risk ?

We may recall the definition of Risk:  “Risk is defined as uncertainty concerning occurrence of loss”. Risk exists if there is something we don’t want to happen – having a chance to happen.

 Uncertainty is measured in terms of  Probability, which is a measure of the likelihood that the Risk Event will occur.

 Now a potential question arises. Can we have control over a Risk? No, we cannot. We can only manage a Risk, which we call “Risk Management”.

 What's Risk Management ?

Risk Management is the process of reducing the threat of loss due to uncontrollable events.There are four techniques of Risk Management. They are outlines below.

Avoiding the Risk

When a company avoids risk, it eliminates the possibility that a particular event will occur, i.e. providing a zero probability of their occurrence. In practice, we  seek to avoid activities that have high potential severity and high frequency. e.g. To avoid the possibility of a suit for any faulty products - not to produce them, which would eliminate both the threat of a lawsuit and the opportunity to profit. With rare exceptions, avoiding risk entirely is extremely difficult. It may not be practical either.

Reducing Risk

A more practical approach is to reduce the risk by taking precautions. Risk reduction is an important element in most companies' approach to risk management. It would reduce the probability that the event will occur and in turn reduce the impact if the event does occur. Typical precautions include putting safety locks on doors to prevent robberies, installing overhead sprinklers to minimize fire damage, and periodic checking motor vehicles to prevent accidents.

Assuming risk

Firms retain (or pay themselves) potential losses that are low in frequency and low in severity. Thus the philosophy is to think - Let the risk happen and be ready to bear the consequences. Many companies draw on current revenues or set aside a "Contingency Fund" to cover unexpected losses. Setting aside money on regular basis could be cheaper than purchasing insurance. Moreover, the company can earn interest on the reserved cash. Such assumption of risk is also called self-insurance or risk retention.

 Transferring the risk

In this technique, we transfer the cost of an undesirable outcome to someone else. For pure risks, Insurance may be a good choice and for speculative risks, other transfer techniques may be used called ‘Alternative Risk Transfer (ART)’. In buying insurance, companies transfer the risk of loss to an insurance firm, which agrees to pay for certain types of losses. In exchange, the insurance firm collects a fee known as a premium.

 By understanding ‘Transferring the Risk’, we begin our long journey called Insurance.