Be Honest about the Cost of Risk Management

The cost of risk management is not primarily salaries and other expenses for the risk management staff.

It is not even the cost of top management time that might be diverted to risk management from other topics.

The real cost of risk management is the cost of the activities that the firm undertakes to prevent or reduce losses.

That was brought home with Hurricane Irene this weekend.  To reduce possible losses, Riskviews spent several hours bringing inside personal things that might have been blown into the house, bringing the kayak in from the marina and filling up containers with extra water.  It will take another half day to put things back after the storm.

Almost all risk management activities have such costs.  Or else they have the opportunity costs that we also experienced this past weekend.  Most people on the eastern seaboard missed out on one opportunity or another because of the storm.

These are the costs of risk management because doing risk management means doing something different than you would have done without risk management.

This past weekend, at least in the New York area, Hurricane Irene was not as dangerous as the hurricane that we were all advised to prepare for.

Risk management is about changing future probabilities.  So that means that these costs will sometimes be incurred when the hurricane weakens before getting to you, or veers off into the ocean and does not even trouble the city.

Some managers are taught to make business decisions based upon cost benefit analysis.  With a cost benefit approach, many risk management actions will fall short.  That is because they will usually look at the actual cost and the experienced benefit.  Many risk management actions, such as hedging or reinsurance may have an expected cost – that means that your projection is that you will reduce profits by taking the risk management actions.

But the real benefit of risk management is the reduction of the likelihood that an adverse event will create unacceptable losses.  Whether that event happens or not and whether or not it is as adverse as expected, is not a primary consideration.  That information is a matter for calibration of the model used to project the likelihood of the adverse event.

So the sooner you have the conversation about the true cost of risk management the better.

And when you have that conversation, be honest.

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