Finance 101: The Tools for Managing Risk
There are all kinds of tools for managing risk—insurance, options contracts, even the morals clauses in contracts between companies and the sports or entertainment stars they hire as spokespersons. In this guide we’ll look at all types of tools you need to manage risk.
Prevention and Safety Procedures
Wearing hard hats in construction areas, keeping borrowing to reasonable levels, and insisting that passwords not be shared are all ways to manage risk. The Occupational Health and Safety Act (OSHA) specifies safety procedures in many work environments, but management must enforce them and develop procedures for activities not covered by OSHA.
Control Environment
The control environment is the overall set of policies and procedures that apply to transactions, accounts, and financial and other information. A control environment can be strong, weak, or in between. In a strong control environment, two or more people must approve certain transactions, passwords are updated often, and people who audit transactions are not the people who execute the transactions. Also, management should receive regular reports on the key controls.
Monitoring
Risks must be monitored because they can change. Changes in the industry, media, regulatory, or economic environment can increase or decrease levels of risk. Also, changes in certain accounts, Internet traffic, and customer or supplier behavior can signal increased or decreased risk. For example, the mid-2000s housing bubble was apparent when 25 percent of condos in some areas were being bought as investments. That should have told experienced real estate professionals to get out of the market before the bubble burst.
Insurance
Property and casualty, life, health, and other types of insurance all work on the same principle. The insurer agrees, in exchange for premium payments, to pay the insured a certain amount or up to a certain amount to compensate for a loss arising from a specific type of risk. The insurer creates a pool of insured people or entities that share the risk (the “risk pool”). The insurer determines the premiums based on the size and likelihood of the losses and the supply and demand for the insurance.
Hedging
Hedging is used to offset financial and currency risk. A hedge is usually a contract to purchase or sell a security, currency, or commodity for a specific price on or by a specific date. For example, a contract that gives a company the right to purchase 50,000 gallons of heating oil for a certain price per gallon next winter is a hedge against prices increasing by more than that amount.
Response Plans and Resilience
Response plans enable an organization to recover from a risk event. Contingency and backup plans help to ensure the resilience of operations and systems. These plans focus mainly on physical facilities, operational capabilities, communication and distribution systems, and IT systems.
It takes time, money, and expertise to develop and deploy the tools of risk management. Not every organization needs every tool, and not every tool is effective in all cases. Thus, management must decide which tools are necessary and cost effective, and how they should be used.
These tools themselves are neither magical nor foolproof. Controls must be tested and adjusted periodically; insurance must be purchased from reputable companies; hedging contracts must be carefully worded; and recovery plans must be practiced before a disaster occurs. In addition, it’s important to know when it is and isn’t appropriate to take risks, which risks are worth taking, and which are prohibited. For more information on risk management, be sure to check out our quick guide, Finance 101: Understanding Risk Management. Good luck!
From The Complete Idiot’s Guide to MBA Basics, Third Edition, by Tom Gorman
