What is Risk Management and why is it important in Business Today? One must first define for oneself the meaning of risk, not only relative to his own life but to his business and financial future. In defining the types of risk, pure or speculative, one will then need to determine the level of risk and uncertainty one is willing to endure to achieve ones ultimate goal. After having answered these primary concerns and depending upon the type of business and style of management being practiced, the risk-taker might decide to create a risk management plan that best suites the business and personal limitations discovered. "The management of risk is a process distinct from its measurement. It involves a set of institutional rules that are largely dependent on (set of) goals." (Focardi & Jonas, pg. 95, 1998).
In the management of risk one may also decide that a risk management plan is too expensive and take their chances.
Risk is inherent to life. The choice to participate in a decision does not preclude the element of risk. Even a non-decision is a decision in terms of consequence. According to Chapman and Ward (2002), "Sometimes the implications of uncertainty are 'risk' in the sense of 'significant potential unwelcome effects on organizational performance." When one makes a decision to take a taxi, or a bus, or the subway to travel to work one is making a choice based on the degree of risk one is comfortable with. The decision to take a bus in the Middle East is not made with the same alacrity as it is in Casper, Wyoming. The intrinsic risk is not equal. Why? Because more buses have blown up in the Middle East than in Casper, Wyoming. The decision to invest in the stock market prior to 1989 was certainly easier than it is today because of the element of risk. Having determined the meaning of risk to be decision-making subject to consequence, then it follows that Risk Management is the organized effort to make decisions that have a positive outcome to the situation.
There are an infinite number of risks one could plan for in life and in business. But prudent business management and "normal" lifestyles do not allow for the anticipation of every event so that a policy to deal with it may be devised and paid for. That, in terms of Psychology, is called obsession. The idea is not to limit exposure to every possible risk, but to prepare for those types of risks that are likely to occur, or irreparable in scope. Culp (2001) lists three fallacies of risk.
Risk is always bad
Some Risks are so bad that they must be eliminated at all costs
Playing it safe is the safest thing to do
Risk is not always bad. If one risks 5 dollars on a lottery ticket and wins 50 dollars then the risk paid off. Some risks, while being unbearably bad must be considered within a probability context. While it is true that the statistical probability is certain that a meteor will hit the earth, the probability is so low that spending all of one's resources to defend against the threat is unreasonable (Culp, 2001). Finally, "playing it safe" can lead to missed opportunities to gain information. True growth in experience dictates exploration into the unknown and therefore the exposure to risk.
An important aspect of managing uncertainty concerns high impact and low probability events which have only adverse consequences, such as earthquakes (Acts of God) or accidents (unintentional errors of judgments or systems failures). The insurance industry has traditionally classified such events as 'pure' risks, distinguishing them from 'speculative' risks which can have uncertain beneficial or adverse consequences (Chapman & Ward, 2002).
The risk manager must determine the amount of exposure and type of risk his company is willing to take. Again, there are several sources of exposure to consider. Jeynes (2002) cleverly identifies ten area of risk as follows: premises, product, purchasing, people, procedure, protection, process, performance, planning, and policy. What can happen? Well, in terms of the premises the risk manager might consider insurance for fire, theft, all types of damage to the equipment, to the software, hardware and even to the continued capability of the firm to conduct business. Product damage could occur in the form of malicious attack such as tampering or biological damage from grain, as is the case of Mad Cow disease. Purchasing faces risk in raw product quality, terms of purchase, timeliness of delivery and cash flow.
People are a large risk factor for a company. Will they hurt themselves, or hurt fellow workers? Will they steal company secrets? Will they misrepresent research or plagiarize discovery? Just imagine the opportunities for insurance in this field alone - which of course is the issue of worker's compensation, which will be addressed shortly.
Company procedures can create risk by being incorrectly designed or unfair. Inadequate protection for the worker can result in business loss of time and production capability. The process by which goods reach the market can fail. Can one insure against the hiring practices of common carriers? They are a major player in the process. Certainly performance must be considered in terms of probable financial loss. The performance not only of the employee, but of the management and related entities contain elements of risk. The name Enron comes to mind.
It is management's responsibility, whatever the size firm, to take action to minimize the impact of losses on the business and to be seen to be protecting the interests of everyone... (Jeynes, 2002). The position of Risk Manager is beginning to take on a rather intimidating scale in light of the financial future of the business. What kind of financial exposure should management be willing to take?
Financial risk takes the form of derivatives, hedging and leveraging in the capital structure (Bremen, 1998) "Derivatives are a collective term for securities whose prices are based on the prices of another (underlying) investment (Numa, 2003)." When a business attempts to base profits on the gains or losses of another it is easy to imagine the risk involved. Hedging and leveraging are other forms of financial risk taking. "As the financial slate of the firm has different links with its real operation, lowering the probability of distress and bankruptcy by reducing the volatility of the cash flows adds value to the firm" (Bremen, 1998). Financial risks also arise with currency fluctuation, as well as market volatility. "...Risk Management and corporate finance are inextricably related, with corporate finance being the backbone of the strategy of risk management" (Culp, 2001).
The risk manager must assess the exposure of the firm before entering into these types of financial rabbit holes.
Then there are the exposures to legal liability in the firm to consider. Every area of risk can also be an area of legal liability. Looking back to Jeynes list of P's one might consider the following as opportunities for legal exposure:
When the building burns down an employee is killed.
The product is found to contain traces of rat feces or has a faulty switch
The raw materials shipment turns out to be stolen property
Management is accused of spying on employees in the locker room where they had an expectation of privacy
The procedure manual had a typo and the step that involved donning safety glasses was missed
The security guard has a flashback and guns down a news team
Exposure is endless and opportunities for legal recourse infinite. It just takes a little imagination, which is a perfect seguing into the area of workmans' compensation.
Business exposure to employee injury was not always taken for granted. It was not until early in the twentieth century that employees began to have coverage that gave them a chance for compensation if injured on the job. "Workers' Compensation with its no-fault approach and limitation of "damages" to partial recovery of tangible losses was the compromise answer accepted ultimately by both employers and employees in most nations" (Williams, 1991).
Before then the Fellow Servant Rule, the assumption of risk, and contributory negligence were common lines of defense against employee injury. The Fellow Servant Rule basically said that if another worker caused the injury or had any part in causing the injury then the company was not liable. In turn, the contributory negligence line of defense said that if the worker himself was in any way to blame for the injury then the company was not liable. Finally, it was assumed that if an employee accepted a dangerous job then there was an "assumption of risk" that the worker understood. Therefore claims against the company were not considered when they occurred in an inherently dangerous situation (Bremen, 1998).
With the standards suggested and imposed by the International Labor Organization (ILO) and the United States National Commission (USNC) workers began to become a risk that was worth considering. "Risk Management, in short, is traditionally viewed as the necessary…