There are four main ways to manage risk: risk avoidance, risk transfer, risk reduction and risk retention. Each is applicable under different circumstances. Some ways of managing risk fall into multiple categories. Multiple ways of managing risk are often utilized simultaneously.
Risk Avoidance (elimination of risk)
Completely avoiding an activity that poses a potential risk. While attractive, this is not always practical. By avoiding risk we forfeit potential gains, be it in life, in business or in with investments.
Risk Transfer (insuring against risk)
Most commonly, this is to buy an insurance policy. The risk is transferred to a third-party entity (in most cases an insurance company). To be more clear, the financial risk is transferred to a third-party. For example, a homeowner’s insurance policy does not transfer the risk of a house fire to the insurance company, it only transfers the financial risk. A house fire is still just as likely as before. Risk sharing is also a type of risk transfer. For example, members assume a smaller amount of risk by transferring and sharing the remainder of risk with the group.
Risk Reduction (mitigating risk)
This is the idea of reducing the extent or possibility of a loss. This can be done by increasing precautions or limiting the amount of risky activity. For example, installing a security alarm, smoke detectors, wearing a seat belt or wearing a helmet are ways of employing risk reduction. Diversification of assets and hedging are forms of risk reduction with investments. Investments in information are a way of mitigating risk because you are better informed, thus reducing the uncertainty. Another way of employing risk reduction is the safety in numbers approach. When discussing risk transfer, we spoke briefly about risk sharing. The larger the number of people sharing risk, the less severe the shared effects will be. Statistically, only a small number of individuals in the group will experience an unfortunate event. Insurance companies exist based on this concept.
Risk Retention (accepting risk)
Risk retention simply involves accepting the risk. Even if the risk is mitigated, if it is not avoided or transferred, it is retained. Retention is effective for small risks that do not pose any significant financial threat. The financial status of the family or individual will determine the acceptability of a risk. A couple of examples of risk retention: A billionaire may not have to worry about insuring his car. An individual may not be able to afford or obtain health insurance. Both individuals are retaining risk, one is because they’re able to, the other is because they have to. Risk retention augments risk transfer through deductibles. With a deductible, we retain or ‘self-insure’ small, frequent occurrences and only utilize insurance for needs over a particular dollar threshold, our deductible limit.