Risk Control Strategies: Avoidance, Reduction, Separation, Duplication, and Transfer in Insurance

What Is "Risk Control"?

Goal: Actively manage risk by: Reducing frequency (how often losses occur) Reducing severity (how bad they are) Improving predictability (making outcomes less variable)

Improved predictability = ↓ objective risk = ↓ coefficient of variation (CV)

Example: Better weather forecasting = fewer surprises = less loss.

. Avoidance

Eliminating exposure completely — probability = 0 (true avoidance).

If probability ≠ 0 → it's not avoidance.

Reactive avoidance:

Stop an activity after loss experience.Ex: Touch hot stove once → never again.

Proactive avoidance

Never engage in the risky activity.Ex: "I'll never go skydiving" / "I don't drink."

Some risks cannot be avoided

Death, illness, natural disasters, weather, aging, etc.

Probability can be small but never zero.

Opportunity cost

You lose potential profits/opportunities by avoiding risk.

"High risk, high reward" — avoiding all risk = no growth.

Risk swapping (risk trading):

Avoiding one risk may create another.

Ex: Avoid flying → drive → now face car accident risk.

Legacy cost

You can stop future exposure, but not past obligations.

Ex: Stop pension plans → must still pay existing retirees

Not always feasible or desirable

Sometimes the benefit outweighs the risk.

Some exposure necessary to make money or progress

When Avoidance Is a Good Strategy

For high frequency + high severity losses.

Example: Driving under the influence (DUI).

Loss Reduction

- reduce severity

Separation

divide exposure units.

Loss Prevention

Aim: lower frequency of loss (make it less likely).

Not possible to make probability = 0 → not avoidance

Loss Prevention Examples

Lock up valuables (reduce theft frequency).

Install wheel lock on steering wheel (thieves pick easier target).

Training programs for employees (reduce accidents).

Wet floor signs / safety inspections / security guards.

Vaccines (can still get flu → prevention, not avoidance).

Snow tires (reduce accident frequency, not eliminate).

Loss reduction examples

Sprinklers, fire hydrants, alarm systems, fireproof construction

Salvage operations, legal defense, rehabilitation, crisis management

Private Protection

Fire extinguishers, sprinklers, standpipes, fire pumps.

Designed to limit damage after fire begins, not prevent it.

Sprinklers → activated by heat, not smoke.

Public Protection

Provided by government (tax-funded).

Fire dept. + hydrants = public protection.

Coefficient of Variation (CV)

Standard Deviation / Mean → true measure of risk.

Objective Risk

↓ when predictability ↑.

CBA Rule

: If risk cost > reward → avoid

High frequency + high severity =

avoidance zone.

When separation should be used

When one loss could shut down operations completely.

When the same risk affects multiple assets in one location (fire, flood, etc.).

When business continuity matters (factories, logistics, warehouses).

Downside of separation

Lower Risk, but Higher Cost

What Is Duplication?

Creating a backup, spare, or standby copy of an important asset or operation that is kept in reserve, not actively used — so that if the primary one is lost, you can continue operating

When to Use Duplication

When the cost of making a copy is low but potential loss is high.

When continuity is critical.

When time delay to restore operations would be costly.

When frequency of loss is low, but severity would be extreme if loss occurs

How Duplication Reduces Risk

Doesn't change frequency of losses (same probability of event).

Reduces severity → because recovery time/cost drops drastically.

Like separation, it improves predictability (less catastrophic uncertainty).

Therefore, Coefficient of Variation (CV) ↓ → Risk ↓.

Control-Type Risk Transfer

Transfer the activity, asset, or operation to someone else.

That other person now controls the exposure — and bears the risk.

Goal of Control-Type Transfer

Eliminate the chance that you'll suffer the loss directly.

If the exposure isn't yours, its losses aren't yours either.

When to Use Control-Type Transfer

The other party can handle the exposure better, cheaper, or more safely.

You have no competitive advantage in controlling that risk.

You can still achieve your goals without owning the exposure.