Step 5: Identify Management Alternatives

by Dana L. Hoag, Colorado State University

Once you know what your risks are, you can consider what options are available to manage them. There are four basic ways to manage or control risks. Some people just try to Avoid risk wherever possible. Metaphorically, people that keep their money under their mattress are avoiding risks of letting others hold their savings. While it is understandable that people want to avoid risks, extreme risk avoidance can have extreme impacts, like significant losses in income potential and even introducing the decision maker to new and potentially greater risks. Again, metaphorically, putting your money under a mattress eliminates any earning potential and exposes you to the risk of fire or flood. A business example of avoiding risks would be to avoid crops like onions or potatoes, which net wild swings in earnings, in order to pick relatively safer crops like hay.

Someone who does not like risk might want to Transfer his or her risks to someone else. This is often a better option than risk avoidance if there is an appropriate market to transfer the risk to. There are many formal modes for transferring risks, such as crop insurance and the futures market. In the case of insurance, risk is transferred from an individual to a corporation that can tolerate more risk.

A producer pays a firm more than the expected indemnity to avoid the risk. The company earns a living from the risk premiums. It can afford to pay for accidents and catastrophes because it is pooling risks over many people, or types of coverage. Even insurance companies are required by law to reinsure so that they maintain diversified pools. A company that specializes in hurricane insurance for example, swaps some of its coverage with a company that covers automobile accidents so that neither company is caught short should a crisis occur that was too large for them to handle, like the devastation that insurance companies had to pay for in New Orleans when hurricane Katrina came through in September, 2005.

The other important transfer mechanism for agriculture is the futures market. Producers swap risks with speculators by hedging and options. The market for swapping is so large as to distribute the risks across many people. Those people that do not mind dealing with risk, may want to Assume or retain their risk. The motivation for putting up with risk is that there is usually a positive correlation between risk and return. Those people that take on more risks, though they have more ups and downs in their lives, make more money in the end. That is, they make more money IF the ups and downs don’t put them out of business first. A study at Colorado State University showed that because women are more risk averse than men, on average, they end up with less savings at older ages. People that assume risks can take actions to make them able to bear them, like having good access to capital.

Of course, whether you wish to retain risk or avoid it, everyone wants to Reduce risk to the extent possible. For example, instead of totally avoiding risky crops or assuming the most risk I can with the riskiest crop I can find, I could diversify my risks. I could grow some onions and some wheat, for example.