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  • Writer's pictureLarry McClanahan

Are You Using These Three Critical Elements of Risk Management in Your Business?

In my last post, I blogged about how business decisions can sometimes have bad outcomes even when you do everything right in the decision-making process.

I’d like to shift gears now and take a look at a helpful framework for assessing and managing risks in your business.

Every potential risk has three elements that you need to consider: probability, severity, and capacity.

1. Probability

What is the probability—or likelihood—that bad outcome x will happen?

Of course, it’s not possible to precisely determine that. But we’re going for a general, statistical likelihood or an “educated estimate.”

The probability of your house burning down is relatively low, assuming you’re not shooting fireworks out of your living room.

By way of contrast, if you operate a logging company or sawmill, the probability that you or an employee(s) will get seriously injured or killed at some point may be relatively high.

2. Severity

If bad outcome x happens, how severe are the consequences? I’m focusing on financial liability here, though it could also include outcomes like damage resulting in short-term business shut down, loss of licensing, reputational liability, and the like.

Even if the probability of a bad outcome is low, if it happens the financial severity could be very high. Consider the earlier example of your house burning. For most folks, replacing a $500,000 home would be a severe outcome.

3. Capacity

This pertains to your ability to withstand or handle a financial payout if bad outcome x actually happens and it’s as severe as expected.

If you have plenty of resources to cover the risk of a bad outcome—and those resources aren’t already earmarked for other purposes—arguably you have the “capacity” to handle it. That’s essentially self-insuring. (Even though you have capacity, there can still be good reason to not self-insure.)

On the other hand, if you don't have the resources, then you’d typically want to transfer the risk to a party that does have the capacity to handle it. And you’d typically do that through buying insurance, which is simply contractually transferring the risk to the insurance company in exchange for the premium you pay.

None of this is rocket science. But I’ve found that distilling risk management to these three critical elements can be kind of a “light bulb moment” for folks who've not thought of it quite like that before. I hope that you find it a helpful framework for weighing and managing your risks going forward.

Feel free to contact me here if you'd like to explore how I might be of help to you and your small business.

The McClanahan Tax Blog is for informational purposes only. See Disclosures page.

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