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The ARRT of Risk Management

The risk management function requires an understanding of loss exposures, those items of value at risk of reduction in value from natural and man-made perils. There are four basic risk management treatments which may be used alone or in combination with other forms to control a loss exposure. Remember that risk is a good thing as it allows productivity to take place from which comes revenues and (hopefully) profit. However, uncontrolled risk is a bad thing as it jeopardizes the value of the assets from which productivity takes place.

There are four basic approaches to risk control. The four risk treatments are:

  • Avoidance
  • Retention
  • Reduction
  • Transfer

To explain the four risk management approaches to risk control, we will use the analogy of driving an automobile. No doubt, the operation of driving an automobile presents several loss exposures that are usually controlled in an effort to prevent auto accidents and the negative consequences of such an event. The loss exposure is somewhat obvious such as wrecking into another auto or person or object, such as a tree. The focus here for explanation purposes is on the bodily injury suffered by the driver due to an automobile crash.

Avoidance

To apply the first risk management techniques to control loss exposures we can decide not to drive, which is avoidance of the exposure. That is a valid decision because, in general, as no automobile accident will occur if we decide not to drive. I say in general because, if one owns an automobile other perils may reduce the value of the auto such as fire, hail, flooding etc. But you get the idea that if we wanted to eliminate the loss exposure of an auto accident we can chose not to drive. This can be applied to other risk as well. I recall reading in a risk management text book that had a picture of a sign in front of a skating rink that stated “We are closed- no insurance”. The owner chose to close to avoid the loss exposure that is avoidance (no doubt because they could not buy insurance which is transfer of risk).

Retention

The second type of risk control technique Retention, is almost the opposite of avoidance. This is when a company not only knows of a loss exposure but treats the exposure with some assumption of the risk. A deductible is a form of loss retention as the insured assumes the first dollar amount of the loss before an insurance company will respond to a claim. Self Insurance is another form of Retention.

Reduction

The third form of risk control is Reduction. This is where a company or individual takes steps to prevent and/or reduce the loss consequences of losses. Back to the operation of an automobile loss exposure, a driver can purchase a car with anti- lock brakes, air bags, crumple-zone hoods, etc to reduce the loss exposure to bodily injury from driving. In the workplace, safety programs and injury management programs are a form of reduction as they seek to prevent and control the cost of injuries.

Transfer

The fourth approach to risk control is Transfer of the loss exposure. This is where an company or individual has given the cost of the loss exposure to another entity or person. Insurance is an example of loss transfer where, for a premium, we shift the cost of the loss exposure to an insurance company. Understand that we may shift the cost of the injuries but not all of the consequences, such as pain and suffering. Insurance is a risk financing technique, not a loss prevention technique, where as the air-bags, and anti-lock brakes sought to prevent or reduce the possibility of injury to the driver. Another form of risk Transfer is contractually, such as when we sign a Hold Harmless Agreement to “hold-harmless and indemnify” an individual. Outside of our auto example, we may sign a lease where, if someone is hurt on the property of the Landlord, the lease contains a hold harmless agreement where the landlord cannot be found at fault and you agree to pay the fees associated with any settlement.

These four types of risk control techniques are often used in combination to treat a loss exposure. That is, we buy a car with safety features (Reduction), we purchase a deductible of our Insurance policy (Retention), to lower premiums, and we buy insurance to Transfer the cost of the risk to a company that can afford to pay a possible large outflow, such as the replacement of an automobile.

The ARRT of risk control can be and usually is applied to all sorts of loss exposures. For example, property loss exposure, such as a building in use, are treated with Avoidance (the not undertaking certain hazardous operations), Retention (use of a deductible), Reduction (use of fire sprinklers), and Transfer (purchase of insurance).

Chris Conti, CSP, CPCU owns RiskWise, a loss control and risk management company and InsureWise, a commercial and personal insurance company. Chris can be reached at [email protected] or www.riskwise.biz or (225) 313-4448 for risk management services and commercial insurance.