5 basic principles of risk management

March 21, 2022

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Risk management is not merely a professional specialty; it’s a basic human instinct.

Every day, we all naturally evaluate and aim to minimize the danger to ourselves and others in a wide range of situations: crossing the street, purchasing a home, opening an email from an unfamiliar source. While risk professionals are well familiar with the core principles of risk management — risk identification, risk analysis, risk control, risk financing and claims management — they are certainly not the only ones to rely on them in their daily thinking and decision-making.

For professionals who practice formal risk management processes based on these tried-and-true principles, a periodic review can be both reinforcing and refreshing. It’s also valuable for lay people to learn about the principles of risk management so they can gain a deeper understanding of why they and their organizations make the choices they do. Using an everyday example is a great way to educate people on risk management principles, so they can then apply these guidelines to real-world operational issues and situations.

#1: Risk identification

This first principle is just what it sounds like: What risks are presented to me, my organization, my customers, etc., in the scenario in front of me?

As an example, think about riding in or driving a car. You might identify the risk of having an accident due to poor maintenance of the car, failure to keep gas in the tank, speeding, or driving under the influence. Another identified risk may be the possibility of damaging property — either the car itself or someone’s property. There is also a risk of financial loss if proper liability insurance is not in place or if the driver gets a speeding ticket, and so forth.

#2: Risk analysis

This stage involves gathering data and considering the meaning of the data points over a span of time. An analysis of the identified risks begs one to ask: How often could this adverse event happen (frequency)? And if it does happen, what’s the worst way it could turn out (severity)?

In our car scenario, the worst that could happen is loss of life. Additional analysis may determine that the risk of being in an auto accident is low because the driver is never on the highway or only drives in good weather during daylight, on roads with speed limits of 30 miles per hour or less, in a well-maintained car, etc. The analysis part of the risk management process should take you through several what-if scenarios and help you arrive at the potential frequency and severity of an event.

#3: Risk control

Risk control offers opportunities to implement solutions that support risk avoidance, prevention and reduction. The risk avoidance technique in our car example would be not to own a car nor ride in a car. In reality, a minimal amount of risk still exists, as you could be hit by a car as a pedestrian or injured while using mass transit, but in certain scenarios, risk can be avoided completely.

Risk prevention aims to reduce the frequency or likelihood of the event or loss. This might mean preventing car breakdowns by following maintenance and inspection schedules, keeping air in the tires and gas in the tank, and following all driving laws.

Risk reduction aims to lower the severity of a particular loss that has already occurred. For example, it might mean ensuring property damage to another person’s vehicle is repaired quickly so the time they are without a car is limited.

Effective risk control considers the various strategies already in place and may introduce new measures based on the findings of the analysis.

#4: Risk financing

This fourth principle focuses on the economics of risk. Risk financing is a way to cover any financial losses that the implemented risk control techniques did not prevent from happening. In our example, even with all the proper maintenance on the car, safe driving, etc., an accident can still occur. By having appropriate auto insurance, funds are generated by the insurance company to pay for the loss — in this case, damage to the car.

#5: Claims management

Whereas risk financing is about managing the financial impact, claims are about managing the harm done. When a loss occurs, a claim may be filed to recover damages. In the car example, a claim may be filed with the insurance company of the driver at fault to recover for the damage that occurred. If the driver at fault was not insured, a different course of action may be necessary to hold the driver personally responsible for the damage.

Bringing risk management principles to life

When educating others about risk management, using an approachable example — such as the one about the car outlined above — can help to make sense of what may otherwise seem like a mystery. Bring the education closer to home by using an applicable, real-world example and walking through the five steps.

Here’s another scenario: Imagine you’re a risk manager walking into a new position, where you’re responsible for the organization’s workers’ compensation program. Drawing on your familiarity with the five basic principles of risk management, your action plan may look something like this:

  1. Risk identification: Consider the kinds of jobs employees perform and where they work in order to identify the greatest risks. Are employees lifting things, operating heavy machinery, using sharp objects to administer patient care, cutting down trees, flying on airplanes, or seated at desks? What dangers might they be exposed to in their daily work environment?
  2. Risk analysis: Collect any relevant and recent historical workers’ compensation data available from the organization’s broker, third party claims administrator (TPA) and internal records. Examine loss runs by occupation, injury type/frequency, root cause and more; drill down to identify what kinds of workplace incidents are happening more often and the possible exposures.
  3. Risk control: Look at the solutions the organization currently has in place to avoid, prevent, and reduce workers’ compensation illness and injury. This can include everything from loss control to safety programs. Then, focus on prioritization and implementing effective solutions to fill the gaps.
  4. Risk financing: Determine the optimal financial structure for the organization’s workers’ compensation program. Is self-insurance right for them, or would it be better to transfer some of the risk to an insurance carrier. Work with an experienced broker for professional guidance.
  5. Claims management: Develop a program that ensures employees harmed on the job are compensated appropriately, as well as receive access to high-quality, cost-effective care and the additional support they need to realize maximum recovery and resume productivity. Consider how the organization and its employees could benefit from partnering with a TPA on the administration of their workers’ compensation claims.

Risk management continues to evolve, but these basic principles are as applicable as ever. It’s also important to keep in mind that the process is meant to be cyclical, rather than linear. Lay people and risk management professionals alike must constantly monitor their environments for new potential dangers, measure the efficacy of current risk mitigation techniques, and, based on the latest findings, repeat the five-step process outlined in the basic principles.