Business, Accounting and Financial Studies | Risk Management

BAFS Study Notes: Risk Management

Hello everyone! Welcome to your study notes for Risk Management. Don't worry, this topic isn't as scary as it sounds. In fact, you manage risks every day – like when you bring an umbrella because it *might* rain. In business, it's the same idea, just on a bigger scale!

In this chapter, we're going to learn how businesses spot potential problems (risks), understand the different types of risks, and explore the smart strategies they use to protect themselves. This is a super important skill for any successful business!

Understanding Business Risks

So, what exactly is 'Risk'?

In simple terms, risk is the possibility of an event happening that could negatively impact a business's ability to achieve its objectives. It's the uncertainty that something could go wrong, leading to a financial loss, damage to reputation, or disruption of operations.

Think of it like this: You're planning a big outdoor event for your school. The risk is that a typhoon signal is raised, and you have to cancel everything, losing the money you spent on decorations and food.

Types of Risks: The First Step to Management

To manage risks, we first need to categorise them. The two main ways to classify risks are Pure vs. Speculative and Insurable vs. Non-insurable.

1. Pure Risk vs. Speculative Risk

This is all about the possible outcomes.

• Pure Risk: This is a situation where there are only two possible outcomes: a loss or no loss. There is absolutely no chance of making a gain. These are the "accidental" or "unfortunate" events.

  Example: The risk of a fire in a warehouse. If a fire happens, the business suffers a loss. If no fire happens, the business is in the same position as before (no loss). The business can't *profit* from a fire.




• Speculative Risk: This is a situation where there are three possible outcomes: a loss, no change, or a gain. Businesses take these risks voluntarily in the hope of making a profit.

  Example: Launching a new smartphone model. It could be a huge hit (gain), sell just enough to break even (no change), or be a total flop that loses money (loss).

2. Insurable Risk vs. Non-insurable Risk

This classification is about whether an insurance company will help you cover the loss.

• Insurable Risk: These are risks that insurance companies are willing to cover. For a risk to be insurable, it generally must be a pure risk. The potential loss must be predictable and measurable in financial terms.

  Example: A business can buy insurance to cover losses from theft, accidents, or property damage.




• Non-insurable Risk: These are risks that an insurance company will not cover. These are often speculative risks because their outcomes are not easily predictable and they are taken by choice. Losses from changes in the market or poor business decisions fall into this category.

  Example: You cannot buy insurance to protect your business against a new competitor who steals all your customers, or against a change in fashion that makes your products unpopular.

Quick Review Box

Pure Risk = Loss or No Loss. (e.g., Accident) -> Usually Insurable
Speculative Risk = Gain, Loss, or No Change. (e.g., New Investment) -> Usually Non-insurable

Common Mistake to Avoid!

Don't think that 'Pure Risk' means the risk is small or not serious. A factory fire is a pure risk, and it can be catastrophic! The word 'pure' only refers to the nature of the outcome (no possibility of gain).

Key Takeaway

Businesses face different types of risks. Some are pure (only downside), which are often insurable. Others are speculative (upside and downside), which are usually non-insurable. Identifying the type of risk is the first step in deciding how to handle it.

Insurance: Your Business's Safety Net

How does insurance work? A simple analogy...

Imagine everyone in your school (1,000 students) puts $10 into a giant pot. That's $10,000. During the year, if any student accidentally breaks their glasses (costing $1,000 to replace), they can take money from the pot to pay for it. It's unlikely that more than 10 students will break their glasses. By sharing the risk, a small contribution from everyone protects individuals from a big, unexpected cost. That's the basic idea of insurance!

Types of Insurance Protection for Businesses

Here are some key types of insurance that businesses in Hong Kong use to protect themselves. These are all designed to cover different insurable risks.

• Employees' Compensation Insurance: This is a legal requirement in Hong Kong! It protects a business against its legal liability to pay compensation to employees who get injured or ill as a result of their work. It covers medical expenses and wages for the time they can't work.

• Public Liability Insurance: This is crucial for any business that interacts with the public. It covers the business if a member of the public (like a customer) is injured or their property is damaged on the business premises.
  Example: A customer slips on a wet floor in a supermarket and breaks their leg. This insurance would help cover the legal and medical costs.

• Motor Insurance: If a business owns vehicles (cars, vans, lorries), it needs this insurance. It covers costs related to accidents, including damage to the company vehicle, damage to other people's property, and injuries to others.

• Fidelity Insurance: This protects a business from financial losses caused by the dishonest acts of its own employees.
  Example: An accountant stealing money from the company's bank account. Fidelity insurance would help recover that stolen money.

• Liability Insurance: This is a broad term. Public liability is one type. Other types can cover the business if its products cause harm (product liability) or if its professional advice causes a client to lose money (professional indemnity).

• Comprehensive Insurance: This is often called a "business package" policy. It bundles several types of insurance together for convenience and often at a lower price. It might include property insurance (for fire, typhoon damage), business interruption insurance (for lost income after a disaster), and public liability insurance, all in one policy.

Key Takeaway

Insurance is a vital tool for businesses to manage pure, insurable risks. From protecting against employee injury to customer accidents, different policies cover specific potential losses, providing a crucial financial safety net.

The 4 Key Risk Management Strategies

Okay, so a business has identified its risks. What now? It can't buy insurance for everything! Smart managers use a mix of four main strategies. A great way to remember them is with the acronym TARA.

The TARA Framework for Risk Management

1. T - Risk Transfer

What it is: Shifting the financial consequences of a risk to a third party.

How it works: The most common way to do this is by buying insurance. You pay a small, certain fee (the premium) to an insurance company, and in return, they agree to pay for a large, uncertain loss if it happens. You are transferring the risk to them!

Example: A shop owner buys fire insurance. They have transferred the financial risk of a fire to the insurance company.

2. A - Risk Avoidance

What it is: Eliminating the risk by not engaging in the activity that causes it.

How it works: This is the most direct approach. If an activity is too risky, you simply don't do it. However, this can also mean missing out on potential profits.

Example: A toy company learns that a new material for its toys might be toxic. Instead of using it, they choose risk avoidance and decide not to manufacture the toy at all, avoiding potential lawsuits and reputational damage.

3. R - Risk Reduction

What it is: Implementing measures to lower the probability of a risk occurring, or to lessen the severity of the loss if it does occur.

How it works: This is a proactive strategy focused on control and prevention.

• Example (reducing probability): A construction company provides regular safety training to its workers to reduce the chance of accidents.
• Example (reducing severity): A restaurant installs an automatic fire sprinkler system. The sprinkler won't prevent a fire from starting, but it will dramatically reduce the amount of damage it causes.

4. A - Risk Assumption (also called Risk Retention)

What it is: Accepting the risk and deciding to bear the consequences and any losses yourself.

How it works: This strategy makes sense for small risks that would cost more to insure or avoid than to simply deal with them if they happen. Businesses often budget for these minor, predictable losses.

Example: A large bookstore accepts the risk of minor shoplifting of cheap items like pens. They assume this small loss because hiring extra security guards (risk reduction) would be far more expensive.

Putting It All Together: A Café Scenario

Let's see how a new café might use the TARA strategies:

• Risk Transfer: The café owner buys Public Liability Insurance in case a customer gets burned by hot coffee, and Employees' Compensation Insurance for the staff.

• Risk Avoidance: After researching, the owner decides not to offer delivery services using motorbikes because the risk of traffic accidents and late deliveries is too high for a new business.

• Risk Reduction: The owner installs non-slip flooring in the kitchen, trains staff on food safety, and buys high-quality equipment to reduce the chance of accidents and breakdowns.

• Risk Assumption: The owner accepts the small risk that a customer might occasionally break a cup or plate and decides to just absorb that cost as part of doing business.

Key Takeaway

Effective risk management isn't about one single solution. It's about using a smart combination of strategies: Transferring the big risks you can't control, Avoiding the risks that are too high, Reducing risks through safety measures, and Assuming the small, manageable risks.