Expert Commentary

The Myth of Risk Management

Risk management does not exist. There, I've said it. Regardless of the nature of the risk, it is impossible to "manage" it. In fact, the expression "risk management" is an oxymoron. Why? Because if risk could be managed, it would no longer be considered risk.


April 2014

With all due respect to Dr. George Head, from whom I learned much of what I know about risk management in the Associate in Risk Management (ARM) program, the real game today is risk financing. Let's have a look at why the notion of risk management is a misnomer. The fundamental precepts of risk management are as follows: avoid, transfer (insurance or contractually, also known as non-insurance), and finance. Add prevent (control) and reduce, and we have the whole cornucopia.

As we all know, most primary insurers have a department variously known as "Risk Control" or "Risk Prevention." When I was a young smart-alecky underwriter trainee at the old Royal Globe Insurance Company, I questioned the need for claims adjustment—if losses were controlled or prevented, there would be no need to adjust them. My instructors, who generally had absolutely no sense of humor, were not amused. They probably recognized the disconnect, but they were not going to admit it to me.

My point, of course, was that it was (and is) impossible to control or prevent every loss. Then as now, those terms, including "reduce," are probably aspirational. Of course, if those aspirations were to be fulfilled, the practitioners would have to find something else to do for a living. Alas, there is no danger of that happening any time soon.

It All Comes Down to Risk Financing

While avoidance is theoretically possible, when was the last time you heard of a company refusing to enter a line of business or retreating from one because the risk manager said it was too risky? Right, maybe one or two. Actually, that's part of what keeps risk managers employed—having to deal with the aftermath of management's business decisions. That leaves risk transfer or retain and finance.

We all know that any form of risk transfer only addresses a fraction of the full extent of the economic hit from any risk event. Insurance recoveries account for roughly one-sixth of the total economic impact of almost any significant loss. So, how do we handle all of that extra loss cost? In most cases, we don't even try. (Hint: It's called passive risk retention.)

Contractual risk transfer is fraught with uncertainties and pitfalls. At the bottom, contractual risk transfer is only tangentially about a contract—it's mostly about credit risk. The risk transferor is assuming that the risk transferee will be able to pay the loss identified in the contract if it should occur. In fact, even insurance represents credit risk, which is why we try to avoid insurers with below A– credit ratings. The other major pitfall of contractual, or non-insurance, risk transfers is the old adage that contracts were made to be broken. Contract breeches comprise the vast majority of civil court cases in this country. No managed risk here.

So, friends, all of this tooing and froing inexorably leads us to one fundamental truth—the only real form of risk management is … risk financing. Please understand that I am not advocating the abolition of risk-reducing techniques such as sprinklers, for instance. Nor am I suggesting that claims should not be aggressively handled in order to reduce their ultimate costs. In fact, expenditures for risk-reducing measures are in reality just another way of financing risk.

My point is this: Unless the risk is financed commensurate with the probability of a loss event, there is no risk management, because there are too many unrecognized and uncontrollable potential loss events to justify using the term "manage."

I suppose that using insurance to cover the effects of catastrophic loss is the most efficient way to handle this type of risk. Or is it? The foundation of meaningful risk financing is twofold—recognizing the probabilities of loss while preparing for the outliers. This, by the way, is one of the strengths of captives.

By now, it should be quite obvious that our attempts to delude ourselves into thinking that the above "techniques" are actually managing risk are, well, falling short of the mark. The old "risk management" thinking went something like this—if we can't avoid, transfer, or prevent, well, I guess we'll have to finance. We are now turning this on its head—everything is risk financing. The other techniques are simply delaying mechanisms that give us some breathing room.

Conclusion

How do we embrace the new risk financing protocols? We can begin by recognizing all of the indirect loss that accompanies every not-insignificant insurance claim. We should approach all of our non-insurance risk transfer arrangements in the same way: Evaluate the degree of credit risk assumed under each agreement and establish a way to quantify it and recognize it. I know this sounds vaguely like enterprise risk management, but perhaps that should be changed to enterprise risk financing.

So, in the spirit of the new paradigm, I propose that the Risk and Insurance Management Society (RIMS) hereby change its name to RFIMS, the Risk Financing and Insurance Management Society. (Yes, while risk cannot be managed, the use of insurance can and should be managed.)


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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