No Risk Management is Betting

So many times, the financial press gets it exactly backwards. (See Bloomberg) Firms who manage their risks by hedging or insurance are reported to be betting and firms who do not are simply subject to the normal fluctuations of uncontrollable events.

But Risk Management offers a real alternative to either betting or being tossed around by the frothy seas of misfortune.  Risk management offers the possibility of identifying and mitigating the most extreme negative events and trends of the world.

Imagine your business owns a building worth $100,000,000.  There is a 1 in 250 chance that a storm will hit your building and destroy the building leaving you with a $10 million piece of empty property and a $10 million clean up bill.  (ignore the business interruption for now).

So the expected cost of that loss is $400,000.  You get an insurance quote for $600,000.  There are two ways you can tell the story of purchasing insurance:

1. The firm can place a bet that its building will be destroyed by a storm.  If there is no storm, then they lose their bet.
2. The firm can manage its risk from a severe storm by buying an insurance policy.

Now if the storm does not happen, the story can be:

1. The firm lost its bet that its building would be destroyed.
2. The firm incurred a fixed cost of managing its storm risk and avoided the volatility of an uninsured situation.

And if the storm does one day hit, the story is:

1. The firm won its bet that a storm would destroy its building and was rewarded by a $100 million gain from insurance.
2. The losses from the storm were covered by the firms insurance.

Risk Management just is not a good story for the reporters, if told right.  For the firm, that may just be one more reason to consider risk management.

Now if the firm chooses not to buy the insurance, the coverage is twisted.  Again read two ways that it might be reported if there is no storm:

1. No story.  Nothing happened.
2. The firm got lucky and did not take a loss on its uninsured building.  They took a bet that had a huge downside for their shareholders for a very small payoff.

ANd if the storm hits, the story is reported as:

1. Tragedy strikes.  Unfortunate event causes $100 M loss.  CEO say “We are just not able to control the weather.”
2. The bet that management took went bad.  That bet was just not necessary.  Now shareholders have experienced large losses because the management was trying to save a little on insurance.  The CEO should be fired.

Unless the firm’s was in the business of long term weather forecasting they had no business making the bet when they did NOT buy the insurance.  THey had no expertise to tell them that they shouldn’t buy the insurance.

They were just gambling.

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