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Accepting Risk

A concept where an individual or business identifies risk and renders it acceptable, thereby making no effort to reduce or mitigate it

What is Accepting Risk?

Accepting risk is a concept where an individual or business identifies risk and renders it acceptable, thereby making no effort to reduce or mitigate it. The potential loss from the identified and accepted risk is considered bearable.

 

Accepting Risk

 

The concept of risk acceptance is commonly applicable in investment fields and businesses as a risk management strategy. Some companies cannot insure against their risks if the cost of bearing it is comparatively lower; hence accepting risk is also known as risk retention.

Risk acceptance becomes an option when small and infrequent risks are identified, and since they are not catastrophic or expensive, no efforts are made to manage them. The impacts of such uncertainties are usually deemed as bearable or otherwise too expensive and are, therefore, accepted as part of the system and dealt with as they occur.

Risk acceptance is the hallmark of a successful prioritization and contingency budgeting because of its reduced outlay on a premium.

 

Summary

  • Accepting risk is the amount of financial uncertainty that an individual or an enterprise can retain without overly insuring, hedging, or mitigating.
  • Accepting risk assumes various financial and organizational approaches meant to provide a financial buffer during risk materialization.
  • While risk acceptance offers a net financial return, the optimal decision to its adoption relies on a manager’s perspective, and not on systematic threats of the market.

 

Accepting Risk Explained

Many business enterprises adopt various risk management techniques to evaluate and classify financial distress probabilities for easier monitoring and controlling. Managers and strategists find that business organizations face numerous business threats that can be avoided or mitigated in relation to the level of growth and the allocated resources.

As a result, businesses resort to control activities meant to strike a trade-off balance between the financial implications of an issue emanating from an identified and acceptable risk, as well as the cost of managing it.

Sources of risks are multi-faceted, and they include natural disasters, overly aggressive competition, exchange rates, and unexpected variability of product prices, legal obligations, and credit risk.

Accepting risk, therefore, carries the same sense as self-insurance. The choice of accepting risk is generally in relation to the small potential financial distresses that materialize each day. However, business enterprises may sometimes accept retaining a catastrophic uncertainty whose insurance costs are not financially feasible.

Accepting risk can take different financial and organizational forms, such as continuously creating a financial reserve, using captives, or accumulating financial resources in special accounts.

In insurance companies, accepting risk can also include deductibles and underinsurance, as well as aggregate deductible plans. All the components require creating a reserve fund in an insurance company to cushion that part of losses that are uninsured because of the deductibles.

Risk retention is not merely a simple decision. Rather, it is an enterprise’s deliberate decision to acknowledge that risks in specific areas will be dealt with as they arise. Risk financing strategy considers the ability to identify and estimate perceived risks.

Accepting risk comes with limitations as well, which are determined by the company’s capacity to absorb financial consequences in the event of a risk. It is essential to managers and business strategists when they are deciding on risk retention policies.

 

Upside and Downside of Accepting Risk

Businesses with insurance programs enjoy an advantage in minimizing expected risk retention costs. The condition that can explain such a line of thought is that the anticipated value of the loss, in the long term, is lower than the cost of insuring it.

In practice, such a condition is seen when insurance companies pay premiums that far outweigh the actual risk. It is true because the risk profile of an individual company differs from the average values assumed when calculating the insurance premiums.

However, one problem with risk acceptance lies in the said optimal risk retention decision that relies on a manager’s perspective, and not the systematic profits and risks perceived by the market. The reasoning that a manager’s decision cannot be assumed to be optimal for the company justifies the concept.

In light of a risk management’s purpose to maximize value growth, a balanced relationship between total costs of risk exposure and saving on premiums is necessary for risk acceptance. Any potential financial loss resulting from an uncovered risk is also an example of accepting risk.

 

Alternatives to Accepting Risk

While accepting risk is considered an appropriate choice in many scenarios, there are additional approaches to mitigate risks in risk management:

 

1. Risk transfer

Rls transfer involves allocating risk from one party to another on a contractual basis. The equitable risk allocation ensures that the responsibility for risk is allocated to the party in line with its capability to control and insure against the risk. The method is commonly used by insurance companies.

 

2. Risk avoidance

Risk avoidance involves eliminating any activity that poses potential loss. It is ideal for risks that are likely to cause a severe impact on a project or business. Managers achieve risk avoidance through policy and procedures, implementation of technologies, as well as training and education.

 

3. Risk mitigation

Risk mitigation involves limiting the consequences of a risk to deal with as it occurs. The strategy is commonly achieved through hedging.

 

More Resources

CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Risk Transfer
  • Business Risk
  • Risk-Adjusted Return Ratios
  • Managing Risks in Investment Banking

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