Lesson 7 of 7 · 15 min
Modifying risk: avoid, accept, transfer or shift
Once risk is measured, it is aligned with tolerance by avoiding it, accepting it (self-insurance, diversification), transferring it to an insurer, or shifting it with derivatives; the choice weighs costs against benefits in light of the organisation's risk tolerance.
In short
- Risk modification aligns actual risk with acceptable risk. It is not always reduction: a portfolio that has become too safe may need more risk. Reduction is hedging.
- Prevention and avoidance: don't take the risk; often a board-level strategic decision. Avoiding risk can mean avoiding opportunity.
- Acceptance: self-insurance (bear the risk, perhaps with a reserve) and diversification. Self-insuring a risk beyond tolerance is denial and bad governance.
- Risk transfer passes risk to another party, usually via insurance, which works by pooling uncorrelated risks. Variants: surety bonds, fidelity bonds, indemnity and hold-harmless clauses.
- Risk shifting changes the distribution of outcomes, mainly with derivatives: forward commitments (forwards, futures, swaps; lock in, no upfront cost) and contingent claims (options; flexibility for a premium).
- Choose by costs versus benefits in light of risk tolerance and the risk profile left over; the methods are not mutually exclusive.
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