Whether it is in your home or business, managing your economic risk is more than simply purchasing an insurance policy. Your first step ought to be a risk assessment identifying both your risk exposures and the magnitude of a potential loss. Armed with an understanding of these two variables, you potentially have three options for how to deal with each risk – risk avoidance, risk retention and risk transfer.
You can think of risk avoidance as that set of preventive steps you can take to help make sure the chances a particular event will occur are eliminated. This can be difficult to achieve. For example, if you were the owner of a home health agency, instituting a system of background checks and requiring personal references would help reduce the risk of retaining an employee who might be involved in the abuse or neglect of a client, but it may only reduce, not eliminate the risk. A manufacturer, however, could look at a product line and conclude that the risks associated with the product were enough to discontinue production – something that actually occurs from time to time in toy manufacturing.
Risk retention is another approach to dealing with risk. When an organization determines that the risk of an event is very small and that any resulting harm is also small, the company can retain responsibility for its own risk. This is done by “self-insuring” for the risk and paying for any losses out of their own funds. A common example of risk retention in business can be found in shipping where there is an election to ship without insuring items. The use of deductibles in insurance is another example of risk retention where the election to a high deductible constitutes a willingness to self-insure up to the amount of the deductible.
When risks cannot be avoided it is time to transfer the risk and this is generally where people look to insurance. In fact, Investopedia literally defines transfer of risk in terms of insurance as:
“The underlying tenet behind insurance transactions. The purpose of this action is to take a specific risk, which is detailed in the insurance contract, and pass it from one party who does not wish to have this risk (the insured) to a party who is willing to take on the risk for a fee, or premium (the insurer)..”
However, insurance is not the only way that risks can be transferred. Many organizations can transfer their risk by transferring the operations that create the risk. For example, a company that made local deliveries could be at risk for liability from accidents involving their delivery vans. This risk can be transferred by retaining a delivery company which assumes the risk of accidents in exchange for payments for the deliveries. Subcontracting and outsourcing are common ways to transfer risk.
Managing risk involves a mix of these three concepts – risk avoidance, risk retention and risk transfer. The more carefully you can think through your options for using these strategies, the more cost-effective your risk management plan will be.