How Real Risks are Managed

The real risk that your $10 million machine that is at the heart of your production line will fail needs to be managed. There are several ways that real companies manage this sort of real risk:

  1. Wait til it breaks and then fix it,
  2. Replace the machine when it is old enough that there is an x% probability that it has reached the end of its useful life, based upon statistics for all users of the same machine and the passage of time.
  3. Replace the machine when it has been used so much that it has reached an x% probability of failure, based upon statistics for all users of the same machine and the actual usage you make of the machine.
  4. Repair the machine when one of dozens of sensors placed within the machine indicates that some part of the machine is starting to operate outside of desired specs.  Replace the machine when such repairs are not cost effective.
This list seems to have a clear analogy for financial firms and their risk management programs:
  1. No risk management program – let the losses happen and mop up afterward.
  2. Manage to some broad industry standard, like premium to surplus ratio or assets to surplus ratio.
  3. Manage to some risk adjusted industry standard like BCAR or RBC.
  4. Manage to a detailed and carefully updated comprehensive risk model.
Of course, 4 is the most expensive course, for both the “real” companies and the financial firms.  Which course you pick depends upon how devastating an event it is for your machine to break down unexpectedly.  If your business can stand a few days/weeks/months without the machine, then maybe the very low cost path 1 is fine for you.
For financial firms, the question is the cost of an unexpected and large excess loss.  How disruptive will it be to have to either curtail business activity until you are able to build back capital or to raise the capital to replace what you lost with new capital?  Can you keep doing business while you settle that question?  What is the opportunity cost of not being able to write business right after a big loss?
The analogy is a pretty good fit.  Feel free to use it when you have to argue for more risk management spend.
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