Methods of Risk Modification | CFA Level I Portfolio Management

In this article, we’ll explore various methods to modify risk exposure, whether it’s increasing or decreasing the risk.

Risk Modification: What’s the Goal?

The aim of risk modification is to achieve the optimal mix of risks for an organization. This involves estimating various risks and deciding whether to avoid, eliminate, accept, transfer, or shift them. Here’s a closer look at each method:

Avoiding Risk

A simple way to avoid risk is to not engage in the activity that exposes the organization to that risk. However, this means forgoing the benefits that come with it. If the potential benefits are outweighed by the risks, the company may choose to avoid the activity altogether.

Eliminating Risk

For undesirable risks that are an inevitable part of the business, a company can choose to eliminate the risk by investing in resources to prevent it. This option is chosen when the benefits of reducing or eliminating the risk are greater than the cost of doing so.

Accepting or Bearing Risk

When the costs to eliminate a risk are higher than the potential benefits, management may decide to accept the risks. This is done efficiently, typically through diversification or by establishing a reserve account to cover losses. This approach is sometimes called self-insurance.

Transferring Risk

Risk transfer involves passing the risk to another party, usually an insurer. Examples of risk transfer include insurance policies, surety bonds, and fidelity bonds. Management should determine that the benefits of the risk transfer outweigh the costs of the insurance.

Shifting Risk

Risk shifting involves altering the distribution of risk outcomes, often through the use of derivative contracts. This method is chosen when the benefits of shifting the risk outweigh the costs of entering the derivative contract.

Summary

Organizations may use multiple methods of risk modification to manage a single risk, and the ultimate goal is to achieve a risk profile that matches the risk tolerance established for the organization. Here’s a recap of the five methods:

• Risk Avoidance – Suitable when the risk is not inherent in the business and the risk outweighs the benefits.
• Risk Elimination – Used when the risk is inherent in the business, and the benefits of elimination outweigh the costs.
• Risk Transfer – Involves transferring the risk to a third party (e.g., through insurance), with benefits outweighing the cost of insurance.
• Risk Shifting – Changes the characteristics of the risk, usually through derivative contracts, and the benefits outweigh the costs of the contract.
• Risk Acceptance (Self-Insurance) – The organization bears the risk and mitigates it through diversification when the cost of other methods outweighs their benefits.