Responses to risk (Tommaso Buganza) - YouTube

What are the different possible approaches to risk management?

What strategies can we deploy in response to risk? Initially, we can consider two opposed approaches:

risk avoidance or risk acceptance. The first approach may seem incorrect

because we have said that risk is inherent in the project and therefore cannot be eliminated.

In this case, however, we do not imagine eliminating all risks from the project,

but we will concentrate, on just one of the project's risks.

To better understand the different strategies,

let's refer to the case of a company developing a new product

designed to provide a series of functions with given performances. 

In order to deliver the product, it is necessary to design some components,

and we imagine that one of these components is particularly complex.

The firm decides to outsource this component's development

but identifies the risk that the outsourcer will be unable to do so.

To eliminate the risk,  the company could eliminate the component from the product.

However, it is crucial to note that eliminating the component and eliminating the risk associated  

with its development also entails a cost for the project.

In fact, eliminating the component will also delete the functions related to it,

and therefore decrease the value perceived by the client.

In other words, the final product will have a lower value,

and the difference between the benefits perceived by the client will correspond to a lower revenue,  

which in economics is comparable to a cost.

It is also interesting to note that if we decide to eliminate the component,

the probability of suffering the related cost equals to 1;

it is a fixed and predefined cost associated with the decision.

The opposite case is the acceptance of the risk. In this case, the company decides to proceed with the project  

by contacting the supplier to develop the component.

This opens two possible scenarios, depending on whether or not the supplier succeeds in completing the contract.

It is evident that if the supplier cannot deliver, this will entail a much higher cost than the previous case.  

The project will inevitably be delayed.

To recover the situation, the company will probably have to contact a new supplier without selecting it carefully,

clarifying the terms of the supply in detail,

and without an effective negotiation of the contract because all this would result  

in further delays and penalties.

The cost associated with this scenario is undoubtedly

much higher than the previous one but with one main difference: it is not certain.

It is now possible to identify an intermediate way

between eliminating and accepting the risk

that will go under the name of compensation. Analyzing the cost of the case of risk acceptance,  

we can notice that a part of this perhaps was avoidable.

In particular, in the event that the supplier does not deliver the project,  

a part of the costs will be not avoidable;

for example, we will have to pay penalties for the delay.

On the other hand, however, some of the costs would be avoidable through some actions

in the front-end of the project. For example, the firm could contact a second supplier  

(perhaps a more reliable, more expensive one)

from the outset asking for an offer, agreeing on the supply, and negotiating the price appropriately

without the pressure of penalties.

The firm could also ask the second supplier to keep the offer valid for a year at the agreed price  

and perhaps even to keep free resources to start immediately with the component project  

should the firm activate the contract.

The second supplier would easily understand that the firm is looking for a real option.

A real option is the right to take action in the future only if needed, a sort of insurance  

to lessen a negative event's impact.

The second supplier would probably accept the proposal but only in return for a payment of part of the contract.

Subsequently, if the contract is activated, this amount will be considered as a down payment.

In contrast, if the contract is not activated, it would remain as a cost for the company.

Looking at the picture it is easy to see that the case of avoidance of the risk involves a fixed and predetermined cost,  

the case of acceptance a much higher but probable cost,  

while the compensation occupies virtually all the space in between,  

allowing to transform potential costs in fixed predetermined and lower costs. 

We could ask ourselves until which point it is worth acting for compensation.

The answer, in reality, is quite simple:

it is worth executing a compensation action as long as the cost of compensation X

is lower than the avoidable cost multiplied by the probability of occurrence of the risky event.

In summary, therefore, we can identify

three strategies for managing risks:

risk elimination, which involves a certain cost,

risk acceptance, which involves a potential cost, 

and risk compensation, which involves a portion of cost sustained for sure 

and another portion, only potential.

There are actually different ways to pursue compensation.

The two most used are mitigation and transfer.

Mathematically they have the same effect (transform potential costs into smaller real ones).

The difference is in the nature of the compensation.  

Mitigations modify the risk acting on either the impact (lowering it as in the case above)

or the likelihood of the event (for example, activating more suppliers in parallel contemporarily

to reduce the probability of not having the final component) or either both things.

On the other hand, to transfer a risk doesn't change it,

but implies that someone is paid to take it on for us.

Insurances are examples of risk transfer.

A car insured against theft

does not have a lower probability of being stolen or a lower value if it is stolen.  

The insurance company simply assumes the damage if the car is stolen  

and receives a revenue in exchange for taking this risk.