How to manage risk effectively to protect capital?

Twentieth century business is confronted with a very dynamic, unpredictable and hostile environment. There is a continuous influx of new opportunities and threats. To keep pace with changing environment demands from an organization a high degree of adaptation and innovation which, as a rule, involve a high degree of risk. If a business fails to capitalize on it or sustains heavy losses, financial disaster is inevitable. For example, if the government of a particular country changes its economic policy which suits its political ideology businessmen will be forced to toe the line; but if any technological change occurs and the government is tempted to accept the change in favor of the people, it will force businessmen to fall in line. In other words, their earlier investments in plant, machinery, and training will be unproductive.

Besides the environmental threat, business always faces the risk of product obsolescence, declining sales, industrial strife, fire, burglary, etc. So if a business fails to minimize its risk a time may come when it will be compelled by circumstances to close down the business. Therefore, while dealing with risk to protect their capital, the management should establish policies pertaining to

  1. Reduction of Uncertainty;
  2. Insurance;
  3. Hedging; and
  4. Estimation of Profit.

Reduction of Uncertainty to manage risk

One of the most effective ways of reducing uncertainty is to determine planning premises. These planning premises anticipate the environment in which plans are expected to operate, i.e., the environment which the business will face in the near future, If managers have a clear idea of planning premises, they can effectively design their plans to overcome uncertainties. A good manager always anticipate change and look for necessary action in order to handle risks effectively and to protect capital in business.

In this context, two types of premises, namely, external and internal, are required to be properly studied. The external premises fall in three important groups: the general environment, which includes economic, technological, political, social and ethical conditions; the product market, which includes conditions influencing demand for product and service; and the factor market, which has to do with land, location, labor, material parts and capital. The internal premises include such things as capital investment in plant and equipment, strategic policies, and approval of sales forecasts.

Though internal premises are contingent on external, yet they form a significant part of the planning scene. Planning premises help companies to reduce uncertainties. For instance, technological forecasting enables an organization to minimize technological obsolescence; social forecasting unveils the dimensions of the social scene of tomorrow; political forecasting helps businessmen to assess the various political indices which are likely to affect their operations.

Role of Insurance in risk management

Another effective way of dealing with risks that cannot be altogether eliminated is to go in for insurance. Though insurance is not available for all types of risks, yet it offers protection against the loss of capital flowing from some common risks which are usually confronted with.

Insurance helps in eliminating or minimizing risk because the insurer undertakes to make good the loss if it occurs. But to be eligible for this the insured company has to pay a premium for the risks against which insurance has been sought. For instance, if there are a hundred factories in a town, there is likely to be a serious fire at least in one or two each year. The management of these factories does not know when and where the fire will break out, but is quite sure of the fact that, in the event of a fire, it will incur heavy losses. So if each factory contributes a certain amount of money to deal with the risk control, an insurance company can create a reservoir of funds that can be utilized to compensate the owner of the factory in which a fire has broken out.

Insurance against a wide variety of risks is available to business undertakings. Here is a
partial list of possible types of protection.

  • Fire
  • Theft and burglary
  • Employee compensation
  • Lift insurance of employees
  • Public liability Cash or goods in transit insurance
  • Automobile Engineering insurance
  • Marine
  • Aviation
  • Riot
  • Flood
  • Tornado

Although it has become almost a universal practice to have insurance, the fact remains that there are substantial differences in the various policies that are available.

The type and Amount of Insurance:

With regard to the type and amount of insurance, there is a considerable variation in the policies of different companies. Some companies carry a minimum amount of insurance. They help manage risks by covering themselves against the loss arising out of fire, explosion, employee compensation, for which there is not great probability of occurrence. They contend that smaller risks will not break the company. Therefore it is desirable to insure against major contingencies instead of going in for insurance to cover every type of mishap.

At the other extreme, there are some companies which carry insurance against every possible type of risk, for they contend that business is exposed to a host of risks, and that all of them cannot be effectively covered by insurance; hence, whatever risks can be covered will minimize the loss they might suffer.

In between these two extremes, there are some companies which follow the policy of insuring only those risks that exceed a definite amount. They feel that loss upto a certain amount can be easily borne by the company without putting any undue strain on its financial resources and that the premium paid for insurance for a smaller amount is definitely lower than the premium that would otherwise be paid.

In making a rational appraisal of his insurance programme, the manager should give adequate consideration to the following factors in order to manage risks effectively:

  1. The nature and extent of the insurable risks of the company must be properly assessed. If grave risks are overlooked, the company may sustain heavy losses; if minor risks are covered, the company may be forced to pay a premium which may well exceed the cost of the possible loss.
  2. The adequacy and cost of the available insurance coverage must be studied in relation to the type and gravity of the risks faced by the company. In covering the risks, it must see to it that the policy purchased protects it against grave risks.
  3. The ability of the company to withstand the quantum of loss. Some companies are financially so strong that they can sustain a loss of Rs. 2 crores to 3 crores, whereas others go bankrupt even if they incur a loss of one to two lakhs of rupees.

Refer the following articles
1. Role of Hedging in risk management.
2. Estimation of profit in risk management.

Share the Knowledge: