Modifying risk: prevention, acceptance, transfer and shifting

Measuring tells you whether exposure is inside tolerance. When it is not, the framework needs something to do about it.

What does it mean to modify risk?

Risk modification starts from the tolerance set in governance and the exposure that has been measured, and then aligns the two. It is not strictly risk reduction. A balanced fund that targets 60% shares may drift to 45% shares after a long fall in share prices. Its risk is now below what its return target needs, so modification means buying shares to bring risk back up. Most of the time, though, the work is about reducing risk, and risk reduction is commonly called hedging . A hedge is a transaction put in place to reduce risk, either to eliminate it or to bring it down to an acceptable level.

What are the four methods?

Memorize

Risk modificationalign actual risk with acceptable risk; not strictly reduction

• Prevention and avoidance Memorize do not take it, or make it less likely
• Acceptance Memorize keep the exposure, efficiently
  • Self-insurance Memorize bear it, or set aside a reserve
  • Diversification Use it spread the risk so it partly cancels
• Transfer Memorize pass the loss to another party; pooled risks
  • Insurance Memorize premium for cover of a specified loss
  • Surety bond Memorize pays if a third party fails to perform
  • Fidelity bond Memorize covers employee dishonesty
• Shifting Memorize change the distribution of outcomes with derivatives
  • Forward commitments Use it forwards, futures, swaps: lock in, no cash up front
  • Contingent claims Use it options: keep one side, pay a premium up front

Method	How it works	Example
Prevention and avoidance	Do not take the risk, or reduce its likelihood	A fund refuses to trade an untested asset class; a firm adds backup power
Acceptance: self-insurance	Keep the risk, possibly with a reserve	A retailer budgets for small shoplifting losses instead of insuring them
Acceptance: diversification	Spread the risk so that it partly cancels	Holding many small loans instead of one large loan
Transfer	Pay another party to bear the loss	Insurance; surety bonds; fidelity bonds
Shifting	Change the distribution of outcomes with derivatives	A bakery chain buys wheat futures; an exporter sells currency forward; a fund buys put options

Prevention and avoidance

Risk prevention and avoidance means taking steps so that the risk is not borne at all, or is less likely. Avoiding every risk is neither possible nor wise, because avoidance gives up the benefit of the activity. A company that never sells abroad avoids currency risk and gives up its foreign customers. A saver who never buys shares avoids stock-market losses and gives up the long-run growth that shares offer. Insurers lean heavily on prevention: a property insurer charges less for buildings with sprinklers and alarms. In organizations the decision to avoid is normally strategic, made by the board as part of setting tolerance. It excludes activities outside the firm’s expertise so that management can concentrate on risks where it can add value.

Acceptance: self-insurance and diversification

Risk acceptance keeps the exposure but does it efficiently. Self-insurance is bearing a risk that is undesirable but too costly to remove by outside means. It may simply mean bearing the risk, or setting up a reserve. A household may skip the extended warranty on a new washing machine and pay any repair from savings. Banks self-insure by holding capital and loan loss reserves.

There is a fine line between self-insurance and denial. Self-insurance fits good governance only when the retained risk is inside the tolerance. A trading firm that says it cannot bear a loss of more than USD 400 million, and then leaves an unchecked fraud risk that could cost USD 1.5 billion “because it is self-insuring”, is violating its own governance.

Diversification is the other form of acceptance: holding exposures that do not move together so that part of the risk cancels. It is central to portfolio theory and a natural starting point, but it is usually not enough on its own.

Transfer: insurance and bonds

Risk transfer passes a risk to another party, most often through insurance . In an insurance contract the insurer agrees to cover some part of a loss from a specific event, in return for a premium paid by the insured. Insurance works through pooling or diversification. The insurer sells many policies with low correlation, and charges a premium that covers expected aggregate losses, its operating costs and a profit.

Two close relatives are:

• A surety bond : an insurer promises to pay if a third party fails to fulfill its obligation. Used when one party bears the cost of another’s non-performance, for example a contractor that does not finish the work.
• A fidelity bond : a variation that covers losses from employee dishonesty.

In this context “bond” does not mean a debt security. It means assuring one party that it will not bear the risk of another’s acts. Indemnity clauses and hold-harmless arrangements work similarly.

Shifting: derivatives

Risk shifting changes the distribution of risk outcomes. Where insurance moves a loss to a pool, shifting moves part of the distribution of outcomes to another market participant, and is the bulk of hedging for financial organizations. The tool is a derivative, an instrument whose price derives from an underlying asset or rate. The derivatives used for this fall in two groups.

• Forward commitments (forwards, futures, swaps) oblige both parties to transact at a future date at a price agreed now. No money changes hands at the start. They lock in an outcome and give little flexibility. A treasurer can lock the rate at which a future foreign cash flow converts.
• Contingent claims (options) give one party the right, not the obligation, to buy or sell. The buyer pays a premium up front, and then keeps the favorable side while being protected against the unfavorable one.

Dealers take the other side of these trades and usually pass much of the risk on, until it rests with someone who is willing to bear it.

Go deeper Locking in or keeping the upside: forward versus option

An exporter will receive EUR 5,000,000 in six months and wants to fix its dollar proceeds. It can sell euros forward at 1.09 dollars per euro, or buy a put option to sell euros at 1.09, paying a total premium of USD 100,000.

Euro in six months	Forward proceeds	Put option, net of premium
1.00	5,450,000	5,350,000
1.09	5,450,000	5,350,000
1.20	5,450,000	5,900,000

The forward gives the same result in every row and costs nothing up front, but the exporter loses the gain if the euro rises. The option costs the premium in every row but keeps the gain when the euro rises. This is what shifting means: the two hedges produce different distributions of outcomes.

Option, euro at 1.20

TI BA II Plus HP 12C

1. 5000000×1.2−100000= 5900000

1. 5000000ENTER1.2×100000− 5900000

ENTER enter (on the HP, puts the number on the stack)

Go deeper Why insurers can bear risk more cheaply

A single household cannot pool its own house fire. An insurer can: with many policies whose claims are not correlated, total claims are fairly predictable even though each one is not. Pooling fails when many policies depend on one event, such as a hurricane along one coast, so insurers limit their concentration, buy reinsurance and sometimes issue catastrophe bonds that pass the risk on to bond investors. A deductible leaves the insured with the first part of any loss, which reduces small claims and encourages care. It combines transfer with self-insurance.

How do you choose among the methods?

Memorize

There is no clear winner. The methods are not mutually exclusive, and most organizations use all of them to some extent. The decision is always a trade-off of costs against benefits (the cost-benefit of risk modification ), weighed against the organization’s risk tolerance. The curriculum’s guidance is as follows.

• Avoid first what offers little for a potentially large cost, especially risks outside the organization’s core competence. Low-cost precautions against such risks should always be taken. But avoidance may not be worth its cost, and it can mean avoiding opportunity.
• Self-insure where it makes sense. Few firms can self-insure everything, and some risks could imperil the whole capital base, but self-insurance saves external monitoring costs and keeps flexibility. Avoidance and self-insurance should be addressed at the governance level and stay within tolerance.
• Insure when the risk can be pooled and the cost of insurance is less than the expected benefit. Some risks are not insurable cost-effectively, particularly those that hit many parties at once.
• Shift with derivatives for financial risks beyond the appetite, which is very common. Weigh the certainty of forward commitments, which need no cash up front, against the flexibility of options, which need a premium.
• Core risks are kept. A bank keeps credit risk, since lending is its business, but may shift currency risk.

Cost-benefit in numbers

$$EL = p \times L$$

$$\text{Premium} - EL$$

Sort the action cards into the four methods, then move the probability and premium sliders in the cost-benefit panel. Notice that the loss tolerance, not the expected loss, decides when “outside tolerance” lights up.

Exam tip When a question asks “which method?”, ask first whether another party takes the loss (transfer) or the payoff pattern is reshaped by a derivative (shifting). Then check whether the cost is justified by the benefit.