Risk retention vs. risk avoidance
Do you recall the risk management technique options available to financial institutions that interact with different level of risk in their operations? Let’s build a recap as a foundation for today’s focus. Financial institutions in practice of risk management technique are concerned with approaches to manage their risk exposures. The options available to them are loss control, loss financing and risk reduction
Let’s shed a light on a loss control and a loss financing technique under the headlines: risk retention and risk avoidance.
This risk management approach is an extreme opposite on the Risk Transfer approach in that it upholds the principle of taking responsibility for one’s action. Risk Retention technique is the intentional decision of organisations to handle opposing risk of a firm internally rather than transferring them to insurance or any other third party. By so doing, the risk of the organization is self-financed and managed. In accounting perspective, this is done by setting an amount/ account aside called Provisioning. The provisioning account is used to service bad debts (defaulting loans). The provision account is a loss financing (reserve funds) account that pays for the potential losses arising from client’s loan defaults.
Organizations make decisions to retain risk when a cost analysis review shows that it is cost effective to handle the risk internally as opposed to the cost of fully or partially insuring against it. Companies choose to retain risk when the premium of transferring them is substantially high. You could rename the risk retention approach as self-insurance.
What financial institutions actually do
The Risk Management Committee strikes a balance in determining the appropriate level of risk transfer or risk retention for their organization. It is unwise to completely transfer your risk and foolhardier to totally retain them. Experience has it that organizations choose to transfer high risk options and retain lower risk. By so doing, they partially retain the risk of their business. There is however no best brilliant way to handle risk. Organizations should work with their risk advisor to determine which risk-financing option is most appropriate for them. The role of risk advisors in this balancing act is crucial. Experienced risk advisors can help organizations determine the best risk-financing program or strategy by conducting a detailed analysis of their risk management profile, risk-taking philosophy and appetite.
Risk avoidance is most times misinterpreted as risk acceptance. On the contrary, it is an approach of risk management that refuses to accept a risk. When the risk exposure is not permitted to come into existence or the causative of a loss is totally eliminated-then this is an avoidance technique. It is simply avoiding the activity that leads to a loss; it is the approach of not engaging in an action that gives rise to risk.
This technique is usually not the best for financial institutions as it deprives them of the profits and opportunities of doing business; so it is the most extreme decision to be taken when the risk level of doing business is also extreme.
Certain risk management scholars do not view avoidance as a risk management tool since it does not entail control of an unwanted event but rather avoid the compromising events entirely. Opposing scholars see it as a tool by distinguishing risk avoidance from risk ignorance. In their view, risk avoidance becomes an option when the extent of risk of a business is known.
For example, during the assessment of a client’s credit worthiness, the credit analyst would have observed some high-risk concerns like- low level of turnover, high credit exposure of the client to other institutions, low credit score and inadequate documentations. This concerns raises high level risk of default and the best option opened to a firm is to avoid this business rather than employing another tool which might be costly to the firm.
Another example can arise when a bank plans to expand its product to accommodate a certain class of the economy. After completing the business plan and proposition, the bank determines that the plan is risky and decides not to pursue this strategy/product. They have strategically avoided the activity, so the loss does not arise.
Risk avoidance is a loss control technique and most times saves the firm from employing loss financing tools. This technique might not totally sway you from a business opportunity but suggest a better approach or timing for a business. Risk avoidance is the least expensive control tool if it turns out to be the best decision and it could also be the most expensive if the outcome differs.
Financial institutions employ a combination of techniques to manage their risk and choosing strategies that best suits their line of business. Whichever the decision taken from time to time, it is imperative to be intentional about this and keeping a log (register) of these decisions for reference to guide future decisions.
“All transactions are not compulsorily approved. A decline (risk avoidance) might be your best bet” – CEO Tatoni Consultant
Today’s Challenge: When there is risk, there is gain. Does risk avoidance hinder a business more than it helps the survival of a business?
Akinyomi an expert and well trained individual in the field of credit risk management. He is the CEO of Tatoni Consults