How to determine the true cost of risk management Featured

9:01pm EDT May 31, 2012
How to determine the true cost of risk management

Risk management is the process of identifying and assessing risk, then prioritizing resources to minimize the impact of losses. But what is the true cost of risk management?

Jonathan Theders, president of Clark-Theders Insurance Agency, previously addressed the assessment process with the 1-5 rating scale for risk severity and frequency in the April 2012 issue of Smart Business.

“Focusing on a risk management approach can earn better pricing, reduce out-of-pocket costs and provide a more stable environment for your employees and customers,” Theders says. “But most important is that it helps you prepare for things that might happen before they happen.”

Smart Business spoke with Theders about how to minimize losses and monitor your exposures.

What are the components of risk management, and how can a business determine which components to use?

There are four components to risk management: risk avoidance, risk mitigation, risk retention and risk transfer.

Risk avoidance is when something is too risky, so you decide not to do it. You don’t have the right capabilities to handle it, so you avoid that practice entirely. For instance, if you are concerned about hurricanes, locate your business in an area in which hurricanes do not occur — at least not typically. There is no reason to insure against that risk because you’ve avoided it.

Next is risk mitigation, or prevention. Once you know what could potentially happen, determine if there are tools, steps, procedures or policies you can use for prevention, or at least reduce its damages.

Then there is risk retention. Every day you assume some risk that is uninsured but decide you’re OK with bearing it yourself.  Sometimes when you implement a mitigation or prevention program, you realize those programs have limited the occurrence of that particular risk to such a minute amount that even if it did happen, you feel comfortable retaining it.

Finally, there is risk transfer, which is sending the risk to somebody else. Insurance is a common tool of risk transfer. If your $5 million building burned down, you do not necessarily want to put that on your company’s balance sheet.  So you contract with an insurance company to transfer the $5 million of risk to it and you pay a premium for it to assume that. You paid the premium, it bears the risk.

How can mitigating risk benefit a business?

Different insurance companies look at the transfer of risk differently, and the price can fluctuate. That’s why it’s so important to communicate to the insurance company what you’ve done to minimize risk. If you have implemented a fire suppression system, disaster recovery plan or something else to mitigate risk, explaining those mitigation techniques will give the insurance company underwriter greater comfort.

Many companies and their agents poorly communicate to their insurance company what they do to prevent risk. They offer information about the construction type, geographic location and the value of the building and it may stop there. Those factors result in the computer tabulating a cost.  What the computer doesn’t know are the risk management techniques that you have in place.  It does not know that you have a policy that prevents employees from smoking on premises, or that all combustibles are stored in UL-approved storage containers.

If you are doing things to prevent a major catastrophe, the underwriter can provide a lower price.

What else can be done to transfer risk?

You can also transfer risk through releases or waivers. We’ve all done something that is risky, whether it’s parachuting, bungee jumping or riding a horse, where you sign a form that releases the company from liability. You are saying, ‘I know I am going to ride a horse. It is risky, and I am assuming all liability if I get hurt.’

What is the true cost of risk, and how is it affected by the components of risk management?

Your true cost of risk is not only the premium you pay but all of the out-of-pocket costs. It’s the downtime of your business if something were to happen, the loss of an employee or the fact that you’re out of business for two months. Maybe you bought insurance to replace your income while your business is out of commission, but your key employees have gone to a competitor because they have to work.

If your $500,000 building burns down, you don’t just lose $500,000. You lose significantly more. In fact, the building may only be 15 to 20 percent of the total loss.

If your business goes down, can your product or service be easily replaced? Your cost of risk is higher if you are easily replaced. However, if you are the only source of a particular product or your competitors are at full capacity and can’t take more work, your cost of risk is lower.

Take, for example, a business that makes its own glass. But glass is only a small component of its overall product. It takes raw materials and heats them, but competitors can make the glass cheaper and more efficiently than it does.

With that operation comes extreme heat and propensity for damage to the building. At the time, it made the glass because it couldn’t get anyone to make the quality it wanted for its product.

Now, the product is readily available, so it decided to transfer the risk by buying that product from someone else. It decided the risk and the reward of having its own glass-making line no longer made sense.

From an insurance standpoint, the benefit is that one of its riskiest propensities for fire is being eliminated. At that point, the policy is re-evaluated and because the overall fire risk is lower, there would be additional savings or credits.

Jonathan Theders is president of Clark-Theders Insurance Agency Inc. Reach him at (513) 779-2800 or jtheders@ctia.com

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