Question

Discuss the meaning of Risk Management. Identify and briefly describe the 4 basic techniques available to the risk manager for dealing with pure risks and give an example of each.

Answer 1

Risk management refers to the act of identifying, analysing and controlling of threats to an organization's earning potential and capital. Originally the need for risk management arises when an investor considers to invest in a particular investment which has a huge capital outlay.

The 4 basic techniques available are

Risk avoidance

Risk avoidance refers to when a potencial investor identified a risk and can forsee its consequences, tend to avoid engaging in those activities which are riskier. In other words he would avoid it altogether.

Example: A company prefer to buy a new machinery but considering its storage and maintainence cost being higher than the yield fetched by the investment, the company many altogether avoid buying a new machinery.

2. Risk Mitigation

It refers to a business choosing that type of investment which is least riskier among all other alternatives available to them. This technique is used when risk cannot be avoided. It only the question of which is the least riskier.

Example: An automobile engineer wants to mitigate risk by recalling a certain model and does all research on its potential cost. If the amount to be paid to buyers for the losses incurred caused by the faulty vehicle is lesser than the cost which is incurred to recall to the vehicle then the engineer would prefer to pay the buyers instead of recalling the vehicle.

3. Transfer of Risk.

This is the bestest technique among the 3 other techniques. It refers to when a risk is transferred the burder is shared or wholly transferred. The contract of insurance is used as a classic example for this technique

Example: when a person gets himself insured on life insurance then in this case the risk of him not being alive during the term is transferred to the insurance company. At the time of death of the insured the family would be given a a lump sum amount which is sufficient for them to run their livelihood in the absence of the bread winner.

4. Risk Acceptance.

The companies usually retain or accept some percentage of risk while the have anticipated the future profits to be generayed by them would be far greater than the accepted risk.

Example. Some pharma companies often accept risk while developing a new drug because they are already sure enough the the research cost incurred for the new drug won't outweigh the profits generated by the drug in the future. In this case the accepted risk is the research cost.