Raising Entrepreneurial Capital Chapter 11: Risk Management

Risk defined Risk is the possibility of loss. implies a situation involving multiple possible outcomes, and at least one of the possible outcomes must be negative. preparations for those events range from insurance to quality control to worker safety campaigns and loss prevention.

Effects and types of risk Risk has two negative effects, the creation of uncertainty and the need to divert resources to offset possible losses, i.e., to create reserve funds. Pure risk involves only the possibility of loss. Pure risk can be from fires, hurricanes, workplace injuries, or “slip and fall” incidents involving customers. Speculative risk involves the possibility of gain, as well as the possibility of loss. The willing acceptance of risk, is normally taken because of the potential gain. That is a prime motivation of entrepreneurs and gamblers.

Risk management defined the identification, analysis, and treatment of exposures to loss. Those exposures may involve either pure risk or speculative risk. Risk management has been described as an art, a science, and as “structured common sense.”

Active and reactive Pre-loss planning is a core strategy for business continuity remediation and recovery are also important. procedures must be put in place to minimize the occurrence of loss and to minimize the financial impact of the losses that do occur.

The Risk Management Process Determination of risk management objectives Identification of exposures to loss Analysis of exposures to loss Selection and implementation of risk treatment methods Administration of the risk management program

Risk management objectives Risk management objectives are stated in two time frames, pre-loss and post-loss. Pre-loss objectives are those things that are to be accomplished in risk management before any losses occur. Typical objectives include cost effectiveness in risk management practices and minimization of losses or loss-producing “incidents.” Typical post-loss risk management objectives include survival of the firm, minimization of the impact of the loss, and maintenance of reputation.

Identification of exposures Exposure identification is the critical component of successful risk management. This is the part of the process that must be ongoing and systematic. There are many strategies for exposure identification, including periodic inspections, the use of checklists and exposure surveys, consultations with employees, analysis of financial statements, and the use of outside consultants.

Analysis of exposures to loss A critical exposure is one that would bankrupt the firm. An important exposure is one that would cause serious disruption to the firm, e.g., the need to borrow money. A bearable exposure is one that could be treated as a current expense with no material impact on financial results.

Risk treatment methods Risk management methods are divided into risk control methods and risk financing methods. Risk control methods are those activities that affect the frequency or severity of loss. Risk control methods include avoidance, loss reduction, and loss prevention. Risk financing methods are the strategies that are employed to pay for the losses that do occur. The fundamental risk financing methods are retention and insurance.

Administration review and evaluation of the risk control and risk management methods that were chosen. Key questions: Did the chosen procedures work? Did they have the desired effect, i.e., the reduction of losses? Were they cost effective? Remediation, correction, and general monitoring of the risk management activities will be the emphases of this step in the risk management process.

Core Risk Management Principles Risk management is a process, not an event. Exposure identification is the key to successful risk management Loss control efforts will pay for themselves Pre-loss planning is the key to post-loss survival Bearing some loss can be rational

Loss control efforts Prevention and reduction of losses is often the most cost-effective approach to improving the overall risk management strategy of the firm. Controlling losses in the first place reduces indirect costs, such as supervisor time and time lost by “onlookers” at workplace incidents. These sometimes “hidden” costs are often greater than the direct costs of the loss. The most important reason for loss control, however, is that it can reduce insurance premiums markedly. Insurance companies reward “good behavior” in their premium structures.

Common Exposures to Loss Direct property exposures Consequential property exposures Liability exposures Human resources exposures Financial exposures Operational exposures Strategic exposures

Consequential / liability Consequential property exposures are those that arise as a result of a direct property loss. They come from the loss of use of the property that is a consequence of the direct physical loss to the property. Liability is a legal obligation that arises from negligence. Negligence is the failure to act as a “reasonably prudent” person, either by an act or by a failure to act. A finding of negligence results in the awarding of damages for bodily injury or property damage.

HR / financial Human resources exposures include worker health and safety, key person exposure, business continuation agreements, and employee benefits. Financial exposures are those exposures related to the financial system and financial instruments. These include credit risk, commodity risk, currency exchange risk, inflation risk, and liquidity risk.

Operational exposures Operational exposures are those that arise from the operational decisions made by the entity. two sub-categories: failures of persons and failures of systems. An example of a failure of a person is embezzlement Examples of failures of systems include problems with information systems or information technology and supply-chain or distribution-chain problems.

Strategic exposures those that arise from the strategic decisions made by the entity. An example of a strategic exposure is a failure in the research and development efforts, especially market research. Another example is failure in the identification of the threats to people, property, and profits/ revenues. There were some extreme examples of the latter in the events of September 11, 2001, especially in the case of a trading firm with all of its nearly 1,000 employees housed on the same floor of one of the destroyed office towers.

Fundamentals of Risk Control Avoidance is the decision not to conduct an activity or to discontinue a current activity Loss control is those activities that reduce the frequency of loss (loss prevention), or reduce the severity of loss (loss reduction), or improve predictability of loss Non-insurance transfer transfers the property or liability that creates an exposure to another entity. Examples of this include out-sourcing business functions, leasing business property, disclaimers, and formal legal strategies such as hold-harmless and indemnity agreements.

Overall risk control includes all of the following areas where the techniques mentioned above are applied. Personnel safety Industrial hygiene Compliance, e.g., with OSHA Security of people, property, and data Property conservation Liability prevention and defense, e.g., product quality control

Fundamentals of Risk Financing Retention involves absorbing losses within the entity’s own financial resources. Insurance involves sharing of losses within a group of entities that are “similarly situated.” Financial derivatives are used to offset the speculative risk involved in financial assets. Derivatives include futures and forward contracts and options contracts.