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“Small But Frequent Losses Can Harm A Firm?!”

“Small but frequent losses can harm a firm”.  This statement is applicable in risk management wherein small but frequent losses can affect financial performance.  On the other hand “Do not burn a forest because you want to kill a bee” is also applicable in risk management in that firms should not overcommit resources in fighting small risks.  In our last article we highlighted that “the level of resources (time and money) that a firm should allocate to risk management should be commensurate with the risk”.  All the possible risks that can strike a firm should be analysed in terms of how often they are likely to strike (Frequency) and the quantity of loss in dollars terms if they strike (Impact).  In Risk Analysis, a combination of frequency and impact is known as ‘Risk Magnitude’.  Identified risks are then ranked according to ‘risk magnitude’ starting with the biggest risks. Having identified and ranked the risks according to risk magnitude the next question is “so what action should organisations take?’. Enter, 4Ts of Risk Management, the ‘Risk Manager’s Toolbox’.

Tolerate

If the risk magnitude is low and within the organisation’s risk appetite, you can just accept and live with it with no mitigation at all.  A classic example is that of stationery items such as pens. There is a risk that employees can take pens home after work every day.  But then, a firm can just tolerate as this risk will be within its risk appetite.  Not that, firms encourage staff members to take small items home, but the cost of putting in place risk mitigation measures to control such losses is not commensurate with the risk magnitude.  The point is, there are certain risks that an organisation just tolerate or take just minimal action to mitigate.  For example, Banks ‘tie their pens’ which are used by customers to complete transaction slips but there is still a minimal risk that a customer can take the pen. Small but frequent losses can negatively affect financial performance. Organisations should continuously keep a careful watch on these perceived small risks and measure their impact to financial performance.

Treat

If the risk magnitude is above the firm’s risk appetite, management should first explore avenues to mitigate the risk.  Risk mitigation is where firms put in place measures to reduce the frequency of loss and/or impact of loss in dollar terms if a risk strikes.   For example, to avoid small losses, a company can implement physical checks at exit points where outgoing people are physically checked (embarrassing though but necessary in certain instances).  In countries, which are high prone to terrorism, you will see high techno-gadgets such as bomb detectors used to scan people and motor vehicles before entering a business premise.  Business and risk are fellow travellers and that being said, business must not stop. Management should explore ways to treat the identified risks to be within the firm’s risk appetite.

Transfer the risk

Risk transfer is where organisations transfer the financial burden of loss to another party.  Traditional, tried and tested mechanisms of risk transfer is insurance where organisations pay an amount to an insurance company (premium) and in return insurance companies pay for the financial loss if the insured risk strikes.  Firms should ensure that they have adequate insurance cover to cover the risks that can strike them. Insurance is technical and use of reputable risk advisory and broking companies is encouraged to avoid disappointments when a loss happens. There are other Alternative Risk Transfer mechanisms such as formation of self-administered funds that can be called upon to fund losses as and when they occur.

Terminate

This is the last resort in the Risk Manager’s toolbox.  This is where an organisation makes a strategic decision not to partake into the targeted project or to stop operations due to the high magnitude of the identified risks.  That is, no mitigation or risk transfer mechanisms can be put in place to take the risk down to within the organisation’s risk appetite.

In conclusion, businesses should not overcommit in fighting small risks (Do not burn the forest because you want to kill a bee).  On the other hand, remember, “Small but frequent losses can harm a firm.

Joey Shumbamhini is the Principal Officer for CBZ Risk Advisory Services (Pvt) Limited.  He writes in his own capacity.  For feedback relating to this article you can contact him on simonsays@cbz.co.zw

 

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