Understanding Insurance

2. Categorizing risks

We end the first article of this series What is risk? with a few questions about how we should react to the risks that we are always facing all the time. Should we keep worrying too much to the level we are paranoid enough for not doing anything? Or, should we just be a complete ignorant, if something bad happens, let it be, we have no control anyway? Or, is there anything we can do to manage them?

To answer these questions, first of all, we need to sort out risks into several categories. The simplest and most common way is categorizing risk based on frequency and severity. Combinations of these two factors lead us to dividing risk into four groups, namely:

1. Rare and not severe (low frequency, low severity)
2. Frequent but not severe (high frequency, low severity)
3. Rare but severe (low frequency, high severity)
4. Frequent and severe (high frequency, high severity)

These four risk categories can be described in the following risk matrix:

Source: Optiongray.com

Actually not all of four risk categories above worth it to worry about. Group 1 risk (LFLS) should be ignored, no point wasting time worrying about them too much then planning or taking certain steps to deal with. The possibility of our fingers being cut by the edges of the paper is an example. It is rare and if really happens, it is not life-threatening. A wash of antibiotic liquid and a small band aid cloth is sufficient to solve the problem. So, the first choice someone can make against a risk is to ignore it.

As for group risk 2 (HFLS), since it often happen, someone might have to do something. There are people who easily lose pens as being left in various places such as meeting rooms, boss’ office, colleagues’ desk, canteens, security guard posts, parking areas and so on. Whenever and wherever he pulled out the pen, it was going to be the last moment he has seen it. He simply need to get a new pen for next use.

A high level of frequency (occur many times) allows a person to predict the level of loss that he may suffer in a certain period of time. This person is able to guess pretty accurately how many pens will disappear in a month time. Say, on average, he will lose 10 pens in a month and one pen will cost IDR 5,000. Thus he must budget Rp. 50,000 each month to buy pens. For a forgetful and careless person like him, it is definitely not wise to buy an expensive golden-wrapped pen, if three days later it will have gone anyway. The decision to set aside certain amount of funds to deal with the risk is called “to retain”. The amount of Rp 50,000 in this case is called the level of retention.

If the person is lucky enough, the needs of all kinds of stationery are fully provided by the company. Every time losing his pen, he just needs to walk to the stationery cabinet and pick up a new one. In this situation, from his point of view, he has transferred the risk of losing pen to the company. In other words, it is the company that is now retaining a loss of Rp 50,000 per month. To transfer is another option available for him in dealing with risks of losing pens.

A quick summary, so far we have discussed three choices of actions that can be taken by someone in dealing with risks, namely to ignore, to retain and to transfer.

P.S. For Bahasa Indonesia version of this article, click Pilah-pilih risiko

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