Methods of risk management

Thus, everyone strives to manage their risks and keep them in check.

One way to do this is through insurance. However, before defining what insurance actually is, we will take note of some other methods and strategies for managing risk, so that we can better see the peculiarities of insurance.

3.2.1. Risk avoidance

The simplest strategy of managing risks is to completely get out of their way, that is, trying not to even create situations or carry out activities that are risky, i.e. whereby certain adverse consequences and losses may occur. The strategy of risk avoidance can be applied to almost any situation – just it may not be worth it.

To bring an example from insurance: if someone builds their house on a hilltop opposite the floodplain of a river, they are virtually certain that it will not be washed away by floods, and so on.

Risk avoidance strategy is the best or, in certain situations, the only possible way to manage risks, as in the example above. The risk-averse man „goes for sure.” Yet, in general, we can say that in many situations this strategy is only a rough and approximate solution that requires great sacrifices. That is, in many cases, small (or low-probability) expected damage is avoided by sacrificing high (or high-probability) profits. For example, one doesn’t get on a plane because it might crash and therefore loses a lot of time, and so on. Therefore, in most cases, it is advisable not to “go for sure” but to take a “bit of risk”, while trying to mitigate the extent and likelihood of possible negative consequences. This consideration is common to all other risk management strategies.

3.2.2. Loss prevention

Man knows from his own and others’ experience that a result can be achieved by creating certain situations, constellations, or performing activities that almost attract certain losses, and the same result can also be achieved by creating or performing others that only rarely involve financial losses. In many cases, the kind of situation one is getting into, lies in one’s conscious decision about it, how one is arranging the world around oneself, and what activities one is doing to achieve the same goal. A person’s actions are only considered preventive regarding losses if they always consciously strive to achieve their goal through constellations and activities where the likelihood of damage occurring is minimal, even if the preventive action requires extra effort.

We demonstrate the meaning of the somewhat vague term „constellation” through an example: if a strong lock is installed on the door of an apartment, and perhaps even an alarm system, the owner has made an extra effort to prevent burglary, i.e. a loss. That in itself does not avoid the possibility of material damage, but significantly reduces its likelihood. A strong lock and the presence of an alarm system is a less favourable

„constellation” for a burglar than any unprotected entrance.

Loss prevention therefore means that one consciously tries to reduce the probability of damage occurring by performing appropriate activities or creating a suitable situation.

A loss prevention strategy significantly reduces the likelihood of damage occurring but does not rule it out. If damage does occur in one area, it can have spill-over effects in other areas. Therefore, if we strive for safety, we need to have some strategy in

place to prevent the spill-over of damage that has already occurred. For example, we cannot prevent for sure that we get a serious illness. However, if we are unable to get the necessary treatment, we may lose our jobs, that is, the source of our livelihood, as a consequence of the disease, become impoverished, and so on. And, complete recovery is often a simple matter of money. One such method could be self-insurance, which could help to put a check on spillover damage.

3.2.3. Self-insurance

In the case of self-insurance, we try to counterbalance the negative results that may occur in one of our activities or situations, with the positive results of another one.

Reserving is a generally applicable and widely used method of self-insurance.

Internal risk equalization, on the other hand, is the preferred method only in certain situations. Now we will briefly examine both methods.

3.2.3.1. Reserving

In order to quickly neutralize the effects of a damage that has already occurred or to prevent its further negative consequences, it is advisable to have reserves for „unforeseen events”. Such an unforeseen event is an accident, illness, fire, etc. As a result of these, one may temporarily or permanently lose some of their assets, work equipment, comfort equipment, or an ability. The lack of lost items causes inconvenience and possibly additional financial losses. If, on the other hand, sufficient reserves are available, the lost items can easily be replaced or made up for.

Reserves can be set up in cash or in kind. It is always good to have a few spare types of spare buttons, the right colours of thread, flour, etc. at home, or it is always advisable for a company to have certain spare capacities, e.g. buildings that seem to be redundant for the normal production process. A country needs adequate grain and oil reserves, camp hospitals that can be set up quickly if necessary, and so on. These are examples of reserves in kind. In these cases, the cash reserve is not a sufficient substitute for in-kind reserves. However, in general, cash reserves can quickly bridge most difficulties.

Self-insurance by reserving is one of the most important risk management strategies.

We find examples of it in all areas of life. In several situations, this is the only right method, but in several others, it fails to bring the desired results. For example, if someone is afraid that their house will burn down, it is advisable to have another house in reserve for them. If the first one burns down, they can immediately move on to the second one, and the negative effects of the house fire have already been prevented.

However, this second house can also burn down, so on a sure-what-sure basis, it is good for a person to have a third, and for the same reason a fourth, fifth, and so on, home.

This strategy, in addition to not being available to most people, is very wasteful in this and many other cases, but we can clearly notice an element of self-insurance. We can

therefore state that self-insurance is not an appropriate risk management strategy here.

In such cases, the method of self-insurance must be replaced by insurance.

3.2.3.2. Risk spreading, internal risk equalization

The possibility of using this form of self-insurance is rather limited and can only take place in certain special situations. The essence of internal risk equalization is that the entrepreneur does not invest all his assets in risky companies but splits them between different companies.

For example, an entrepreneur is interested in two lines of business: he operates a beach and grows vegetables on a relatively large plot of land. These two businesses are affected differently by the early summer rain. It hurts the beach shop but it’s good for the vegetable. The same is true in the case of sunny weather without prolonged rain, just in the opposite direction. Overall, this entrepreneur does not need to care what the weather is like, since in each scenarios, he will gain a more or less average profit.

The essence of the strategy: our entrepreneur neutralized the risk of weather with the right combination of activities.

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None of the above strategies are considered to be insurance. The common feature of the risk management methods mentioned above is that the individual who is exposed to the risk acts against it on their own and handles it with individual strategies. Insurance, on the other hand, is the cooperative strategy of risk management, and hence we can give its definition in a second sense.