Responding to the various categories of risk

There are four basic responses available to businesses depending on the category a given risk is placed:

Accept the risk as a cost of doing business, and decide to retain and budget for the risk ( self-insuring the risk)
Retain and budget for the cost of the risk, but take steps to reduce or avoid it
Transfer the costs associated with the risk to a third party, such as an insurance company
Avoid the risk altogether by fundamentally changing some aspect of the business.
Typically, companies deal with low frequency – low severity risks by choosing the first option above, and self-insuring the risk. Using the office supplies example above, since it wouldn’t make sense to install a $50,000 video monitoring system to protect a few hundred dollars’ worth of office supplies, most companies decide to self-insure the risk, and take only nominal steps to avoid recurrence (such as placing a lock on a door).

For high frequency – low severity risks, companies usually choose the second option above, and retain the costs of the risk, while taking steps to reduce or avoid it in the future. For example, while each individual theft in a retail store is not terribly profound, the collective amount of loss at year-end may make it worthwhile to hire security guards or install video cameras to deter and/or prevent shoplifting.

Low frequency – high severity risks are generally best managed by picking the third option, and transferring the costs associated with the risk to an insurance company or other similar external party. Taking the examples above, the costs of the losses associated with fire, natural disasters, or third-party liability and employment lawsuits can be tremendous, and are usually best transferred to an insurance company.

And finally, high frequency – high severity risks are best dealt with by avoiding them altogether. Using the unsound property example above, the property management company should consider immediately notifying the building owner and ceasing its management responsibilities until a new building is constructed.