Risk is an everyday part of life and applies to everything from choosing a job, picking investments or following a lifestyle.
Table of contents
There are five different risk management strategies that you can apply to reduce the potential of an unwelcome outcome and reduce your overall risk exposure:
- Risk avoidance
- Risk-retention
- Risk sharing
- Risk transference
- Risk prevention and reduction
This guide explains the concepts behind each risk management method and when to use them.
Creating A Risk Avoidance Strategy
Avoiding risk is simple to understand – you take steps to avoid participating in anything that is likely to go wrong.
This strategy can apply in many situations:
- Employers might avoid liability risk by not offering in-home services.
- Individuals can choose not to smoke to bypass health risks.
- Investors could opt not to invest in crypto due to market volatility.
Some risks are easier to avoid than others, and it may be that bypassing a risk altogether is a limiting approach, particularly in a business environment.
A company might, say, store a limited amount of data to avoid any non-compliance with regulations such as GDPR and steer clear of potential cyber-attacks.
However, the knock-on impact might be that they can’t offer as many on-demand services as their competitors due to a restricted bank of data on each customer profile.
Understanding Risk Retention
Risk-retention is the opposite of risk avoidance and means you accept the risk before you.
There are some retained risks you can’t avoid, even if you would like to, such as the risk of an underlying health condition you do not know about.
You might decide to retain risk in return for a payoff later down the line – that could mean going for a cheaper car insurance policy with a higher excess payable in the event of a claim.
The risk is that if you are at fault in an accident, you will have to pay a higher proportion of the repair costs, but you still have sufficient insurance to cover higher costs if the claim is substantial.
Of course, your level of retained risk can vary considerably. You might, in this hypothetical example, think about:
- How often you drive.
- Your driving experience.
- The times of day you travel.
- How busy the roads are at those times.
- Your financial ability to cover the excess.
Everybody has a different risk exposure, so here you retain the risk of having an accident and needing to pay higher out of pocket expenses for the return of paying lower premiums for your policy.
You can find out more about car insurance risk factors from The AA.
Risk Sharing Explained
Sharing a risk means balancing out your exposure by dividing the potential impact of a risk with someone else.
The risk itself is the probability of an adverse event occurring within a specified time, so examples of risk-sharing include:
- Diversifying investments or funding streams to split risk between different sources, markets or products.
- Purchasing cooperatives, regularly used in agriculture and energy, pool resources and benefit from lower prices, thereby sharing the risk of price rises.
- Airline risk-sharing, using contracts with competitors to lock in rates to mitigate the risk that an unexpected cancellation rate will leave customers stranded or that airlines will lose out on ticket price competition.
Risk sharing is common in business as a mutually beneficial strategy but is also present in our personal lives.
You might share an insurance policy with a partner or enter into a property purchase with a co-investor, sharing the risk equally between you.
Tax regimes are also a relevant example of risk-sharing. Everyone risks becoming unwell, experiencing a fire, or needing emergency services in an accident.
The risk of any such event occurring and the corresponding financial cost is shared between communities by pooling taxation income to provide services to all.
Social security benefits and State Pension schemes are also examples of shared risk, whereby larger investment volumes are diversified across different asset classes and risk exposure levels, ensuring the fund balances overall risk.
How to Use Risk Transference
Transferring risk to someone else is a way to swerve risk exposure by assigning responsibility for the action incurring risk.
An example could be a commercial property owner outsourcing security to a third-party contractor. If a loss or theft occurs due to insufficient security, the liability is transferred to the security provider rather than the landlord.
Subcontractors often assume risk, transferred to them by their hiring organisation, so robust insurance then moves the cost risk onward to an insurance provider.
Other types of insurance also constitute risk transference. While unable to transfer the personal impact of ill health, health insurance transfers the financial risks of needing a healthcare procedure to the insurer.
Financial risk is assumed for a fee – the premium – and the terms of the risk acceptance are outlined in the policy contract.
This concept explains why insurers require assessments and questionnaires before offering a policy.
Pet insurers will want to know about the animals’ breed, pre-existing conditions and age before deciding on a price they are willing to accept to take on the transferred risk of the pet needing veterinary treatment.
Once you purchase the policy, you transfer the cost risk to the insurance provider – the higher the risk, the higher the premium.
Risk Prevention v Risk Reduction
Our final risk management strategy is a blend of prevention and reduction – both work in harmony but are slightly different methods to mitigate or minimise potential risks.
Risk management is a process, rather than a one-off action, with several steps:
- Recognising the presence of risk or multiple hazards.
- Weighing up the likelihood of those risks coming to fruition.
- Quantifying the cost risk or other risks associated.
- Deciding how severe the risk is and what the consequences could be.
- Opting to accept, transfer, share, avoid or reduce the risk.
Reducing risk involves containing the risk within parameters to stop any outcomes from being uncontrolled.
Income protection insurance is a preventative risk strategy, offsetting the potential financial risk of losing a job or being unable to work.
Risk prevention is similar to risk avoidance, although it is more involved than simply choosing not to engage in something with a risk factor.
An example could include monitoring safety devices in a factory, regular car servicing and MOTs, or implementing concentrated emergency procedures to prevent a risk from occurring, even though the potential for the risk still exists.
Risk assessments are a key part of risk prevention and risk reduction, as a cohesive approach to run through the stages above and decide which risks are significant enough that they require action to prevent the likelihood of the risk happening.
Tips for Managing Risk Exposure FAQ
What Is the difference between risk avoidance and risk reduction?
Risk avoidance means making decisions to avoid encountering any level of risk or exposure beyond that you are comfortable with.
Reducing risk means that you still accept some aspect of risk but take steps to minimise any potential losses by making it less likely that you will incur a loss or ensuring the impact will be less severe.
Is it better to prevent or mitigate risk?
The right approach depends on the type of risks you are evaluating – that might be a health risk, an investment risk, or a risk to your income, as a few examples.
Mitigation means that you can still choose higher-risk strategies, but with an eye on the variables that may offset possible risk – prevention, on the other hand, will make a loss less likely but mean you avoid potentially lucrative opportunities.
What is systematic risk in investment?
There are multiple types of risk, and systematic exposures affect the whole market rather than one particular product or company. Examples of systematic risk include natural disasters, inflation or political instability.
How can I evaluate my total risk exposure?
Risk exists in pretty much every aspect of our lives. Quantifying risk is easier in scenarios such as investments or choosing whether to purchase an asset because you can work out the potential financial loss and analyse the likelihood.
It’s a lot more complex to evaluate health risks, so the key is to look at your desired outcomes or aspirations, contributing factors that make that result less likely, and what actions you can take to improve your position.
What is a retained risk?
Risk-retention means that you accept a risk and recognise that there isn’t anything you can (or wish) to do to reduce it. Leaving your home to travel to work may be a risk, although a traffic accident is unlikely.
You could, potentially, mitigate that risk by travelling outside of rush hour times or using a safer mode of transport, but will normally retain the risk rather than avoiding travel at all.
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