Merchants have been managing risk for a long time. The practice goes back to around 3,000 B.C. – some 500 years before the Great Pyramid of Giza was constructed – when Chinese traders traveling together found a clever way to mitigate the risk of losing merchandise while crossing dangerous rivers. When individual traders carried only their own merchandise during a crossing, each took the risk of losing everything. However, by divvying up their cargo among the other members of the group, then even if one or two vessels foundered in the rapids, no one would lose everything. And so, the concept of managing exposure to loss through the pooling and sharing of risk was born.
Risk Management Today
The same basic concept, though much refined over the centuries and implemented in far more sophisticated ways, remains with us today, 5,000 years later. Companies using a modern risk management approach first try to identify significant potential risks to the business (an unexpected major drop in demand for their products, a scandal involving a top executive, an explosion causing death or injury at a manufacturing facility, etc.). They then assess the likelihood of each particular kind of event actually occurring, estimate how much damage might be caused if it did, and then employ two basic methods to manage the related risk: risk control and risk financing.
Risk control seeks to minimize losses by either avoiding or eliminating unacceptable risks, where it is possible to do so (e.g., avoiding engaging in a particularly risky manufacturing activity by outsourcing it to a third party), and by deploying preventative measures to reduce the likelihood of other risks occurring to an acceptable level (e.g., a pharmaceutical manufacturer adhering to best practice manufacturing protocols to minimize the odds of product contamination).
The second method, risk financing , deals with taking steps to ensure that losses can be financed if and when they occur. This is accomplished through either transferring a risk to a third party, such as an insurer (for a price, the premium, the insurer assumes the risk and finances up to an agreed amount of loss), retaining a risk that cannot be avoided or reduced (and hence bearing the burden of financing the loss), or some combination of both (e.g., insuring a $100 million manufacturing plant for $80 million, and retaining the risk of a $20 million loss).
The Changing Role of Insurance in Corporate Risk Management Strategies
As a key component of risk financing, insurance companies have traditionally developed products based on the assumption that companies purchased them as a means to transfer risk. But as the science of risk management advances and more companies hire dedicated risk management professionals to design and implement their risk management solutions, this assumption may no longer be valid for many businesses. In fact, for many companies, the desire to transfer risk is neither the sole nor even the primary factor driving insurance purchasing decisions.
The reasons for this are varied. For example, a company may buy insurance simply to put a customer at ease or to fulfill a government regulation. Or it may do so for cash flow benefits and access to an insurer’s claims-handling skills. Another reason a company might purchase insurance is to address, for example, a joint venture partner’s concern about a risk that the first company would otherwise feel comfortable about retaining. Or a company simply might want to avoid taking an earnings hit in a given quarter, should a major negative event occur, even though it might otherwise have no concerns about paying for the loss over time.
For these reasons, and many others, a company may purchase insurance even though the need or desire to transfer risk is not part of the company’s agenda. A number of leading insurance companies, including AIG, have developed a variety of techniques to address these kinds of needs. Hence, if your company is faced with requirements similar to the examples above, the best approach is to have (probably a series of) in-depth conversations with your insurance partner, so that the insurer fully understands what’s driving the decision-making process and can tailor a nontraditional insurance solution accordingly. By not having such conversations, you risk paying for insurance that you don’t need.
Insurance continues to play a crucial role in helping companies manage risk by transferring it. But it also serves as a vital risk management tool in nontraditional uses in which risk transfer is, at best, a minor consideration. Today’s corporate risk managers play a critical role in identifying, evaluating, and developing strategies to mitigate and finance risk in a way that vastly improves the protection of their organization’s assets. For those not already doing so, one way to improve, even further is to explore new ways to partner with their companies’ insurance provider to ensure that existing and emerging risks are being addressed by the most effective and cost-efficient means available. Means that today often will include the implementation of both traditional and nontraditional insurance solutions that are better aligned with their companies’ overall risk management strategies, and with the motivations behind them.