The Risk Management Process
Risk Management is a systematic and continuous process by which individuals, families, corporations, not-for-profits and governmental entities identify, assess and manage risk.
Risk is anything that threatens the ability of an individual, a family or larger enterprise to exist and/or grow. Risk management is a discipline that enables people and organizations to deal with uncertainty by taking steps to protect their assets and ability to produce income. The risk management process provides a framework for identifying risks and deciding what to do about them. Since not all risks are the same, risk management goes beyond just identifying risks and includes weighing the various risks and making decisions about which risks deserve attention and how they are best handled. Risk management is a continuous process that, once understood, becomes ingrained in the way you manage your life, family and business.
Kettle Creek follows this process in the work it performs for every client. The process entails:
- Creating an inventory of all assets;
- Determining the Replacement Cost of your assets;
- Identifying key exposures to loss and assessing the risk associated with those exposures;
- Mitigating Risk via avoidance, contractual transfer and/or loss prevention;
- Risk transfer; and,
- Risk financing.
The process is sequential but can start with any one of the steps and move back to the others at a later time.
Inventory Assets – The first step in the process is to inventory assets. The key to assuring that all of your assets are protected is to establish and maintain a comprehensive list of all assets including buildings, personal property, equipment, earnings, automotive equipment, watercraft, intellectual properties and key personnel. Kettle Creek works with and encourages our clients to create and maintain these records.
Value the Assets – The next major step in the process is to fairly and accurately determine the replacement cost as opposed to the actual cash value (replacement cost less real depreciation) of the assets. This valuation is critical to assure the proper level (insurance-to-value) of insurance is ultimately carried because:
- Should a covered loss occur, you need the proper valuation to assure the assets can be replaced.
- Should an uncovered or self-insured loss occur, you need accurate records for tax preparation and treatment; and,
- Most insurance policies penalize the insured if the proper level of insurance to value is not maintained as required by the policy.
There are several important factors that should be taken into account when determining replacement cost of an asset:
- Businesses should not use book value to determine replacement cost. Book value represents depreciated value and does not take into consideration market fluctuations in value or the real cost to replace an asset.
- The cost to replace homes and buildings can vary by community.
- The cost of a home or building does not necessarily reflect the cost to rebuild it.
- The larger the asset, the more accurate the valuation should be.
- The replacement cost of an asset will change over time. The insured should not simply rely on last year’s inflation adjustment Periodically the insured should ascertain the current replacement value via an independent assessment.
- Unique market considerations can influence values materially.
- The nature and the magnitude of the event causing the loss will have a material impact on replacement cost. (For example, consider the impact that a hurricane causing widespread local damage can have on the price of labor and material because of increased demand and reduced supply.)
- For the larger value or unique items, an independent appraisal is advisable.
Identify and Assess Key Exposures to Loss – In order to organize the process, it is best to group the assets by type and then by location. This will simplify the process because in most instances, homes/buildings, contents and other valuables will be subject to the same types of losses whereas motor vehicles are subject to a different type of loss exposure. For instance, homes and buildings are more commonly subject to loss caused by fire, wind, water and smoke than autos which are more likely to be involved in collisions. Once assets have been properly categorized, it can then be determined what possible losses they may be subject to and the likelihood of such events occurring. During this process, it is also important to recognize the liability that arises from owning and operating those assets.
Risk Mitigation Techniques – There are a variety of methods by which risk can be managed including: avoidance, loss prevention, loss reduction, risk retention and risk transfer via insurance.
- Avoidance – While not typically viewed as a risk management tool, it should be recognized that we avoid risks every day by the decisions we make. In most instances, we do have the ability to avoid risk. One simple example of this is when we decide not to do something or we decide not to buy something.
- Loss Prevention – Not all losses are preventable but steps can be taken to reduce the likelihood of a loss. Examples include such practices as using a fence around a pool, wearing seatbelts in a car, using grounded electrical outlets in your home or cleaning the grease traps in restaurant hood ventilation systems. The question that most often arises in designing loss prevention programs is how to achieve the greatest degree of protection for the least amount of money.
- Loss Reduction – Lastly, it is possible to minimize the impact of loss should losses occur. Typical loss reduction measures in a home as well as in business include use of central station fire, burglar and temperature alarms, automatic back-up power generators and sprinkler systems.
Risk Transfer – The most cost effective way to minimize the financial impact of risk is to transfer the risks to another party. There are two fundamental ways in which risk can be transferred to a third party; contractually and through the purchase of insurance.
- Contractual Transfer – It is possible to transfer risk to a third party via contract. Examples are numerous. Using a hold harmless agreement, requiring a legal agreement and requiring evidence of insurance when using contractors, or a landlord requiring a tenant to assume the risk of property damage and legal liability arising out of their occupancy of rented premises.
- Insurance – Insurance contractually transfers risk to an insurance company for a premium.
Risk Financing and Retention – Ultimately, it all comes down to the cost of risk. Can you afford to assume the risk and fund it yourself, or should you buy insurance and transfer it entirely? The answer ultimately is a function of your level of risk aversion and financial capabilities. The decision involves a tradeoff. Individuals and organizations can influence the cost of risk by determining whether to assume risk or transfer it to an insurance company. While in many instances, we do not have a choice of whether to buy insurance because of either governmental (automobile, workers compensation) or other third party (lender) requirements. We do often have the choice of the deductible we choose and the limits we buy. Generally speaking, it makes sense to retain the high frequency/low severity type of loss and transfer the low frequency/high severity type of loss. Accordingly, as a way to manage premium dollars, it is always better to buy higher limits of insurance and pay for those higher limits by saving premium through increasing the deductible.