Risk: The Cost of Doing Nothing

We have used a simple definition for Alternative Risk Transfer (ART), referring to any method used by an entity to shift the cost of a risk to another entity, but without the use of traditional (standard, commercially available) insurance. However, even this simple, broadly applicable term ignores an important aspect of ART. When an entity decides not to take action to address a possible loss exposure or when a business opportunity is ignored, either an active or a de facto decision has been made. Therefore, it can be argued that the decision to take no action is a form of ART.

ART is far more comprehensive and holistic than either traditional insurance or rudimentary risk management. Rather than involving the limited focus on addressing possible loss exposures, ART attempts to assess the impact of a far wider range of operating parameters. Its considerations include a firm’s exposure to financial risk. It also evaluates how long-term operations are affected by opportunities that are not undertaken. Therefore, under ART, the “cost” of not taking a particular action may represent a quantifiable cost that may even be redefined as a loss.

A firm can benefit from assessing all its executive management’s actions, including inaction. Doing so protects an organization from overly conservative managers and directors who, because of their lack of vision or assertiveness, could endanger the firm’s competitive standing or, in extreme cases, its long-term viability.

 

Example: Acme Imaging Incorporated was, up until 15 years ago, one of the industry’s top 10 firms, with sales, at its peak, exceeding $450 million annually. Although markets trends showed that consumer demand was shifting toward digital technology, Acme stayed the course and continued with its traditional product line of cameras and accessories. This past year, sales have dipped below $10 million and the firm is in liquidation. Cost of doing nothing in established market

 

Therefore, a firm that is dedicated to assessing the impact of their decisions should, formally, require that a cost, whenever possible, be assigned to every option for addressing a problem or seeking an opportunity. In fact, considering the cost of doing nothing as a distinct opportunity cost is an effective way to approach the issue.

 

cost related to doing noting on an online order system Example: Firm A has millions of dollars invested in a new, online customer order system. The system works fine and it is used to process 85% of the company’s orders. However, management is upset because the system’s installation cost ended up 20% over their budget. The consulting firm that sold and installed the system asks the firm if they should begin installing the back-up system. Firm A decides to cancel that part of the project. The decision saves them $3,000,000. However, two months later, the system crashes just before the holidays. Firm A loses all of the potential sales over the three days it takes to bring the system back online. The multimillion savings decision that looked good two months earlier has now resulted in lost sales revenue estimated at more than $9 million.

 

In such instances, an entity’s decision-makers can assess its position by determining and assigning costs to its decisions, such as:

 

Project Options
Option A Option A Cost
Option B Option B Cost
Option C Option C Cost
Option D (No action) Option D Cost

 

One simple method is the notion of opportunity cost. Under this concept, the cost of a given action is the value of the best opportunity that is sacrificed when that action is taken. However, costs must be properly evaluated in order to be accurate enough to help with the decision to pursue an activity.

 

Project Options
Option A Option A Cost A’s associated costs
Option B Option B Cost B’s associated costs
Option C Option C Cost C’s associated costs
Option D (No action) Option D Cost D’s associated costs

 

Therefore, determining “costs” is much broader than, say, the purchase price of a given piece of equipment. It may need to include maintenance and repair costs, as well as the cost of insuring the equipment. Naturally, consideration must also be given to the value or income opportunity related to pursuing a course of action. The “cost” of the deliberate choice of not pursing an option may be the inverse of one of the foregone options.

 

Project Options
Option A Option A Cost A’s associated costs A’s associated income
Option B Option B Cost B’s associated costs B’s associated income
Option C Option C Cost C’s associated costs C’s associated income
Option D (No action) Option D Cost D’s associated costs D’s associated income

 

Even the simplest approach can enhance a firm’s risk management goals by adding a necessary dimension to evaluating major projects, maintenance decisions, addressing industry-related trends, and loss exposures. An important element is evaluating a given operation’s level of risk aversion since the lower a firm’s tolerance for taking risks (seeking opportunities), the higher the probability that it will deliberately pass up certain options that could hamper its future. An effective risk manager is one that properly assesses all choices made by its firm. Managing risk does not mean avoiding all risks at all costs.