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Publications
Risk Management: Overview of CORE Analysis
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Definitions of Risk • Calculate Your Business Risk (Step 1)
• Optimize Opportunities to Address Specific Perils (Step 2)
• Reduce the Adverse Effects of Specific Risks (Step 3)
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Evaluate the Effectiveness of Strategy (Step 4)
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Summary •
Sources
There are numerous sources of risk that business owner/operators battle
against to keep their businesses operating successfully. These owner/ operators
use multiple and diverse management strategies to combat their business risks.
Some strategies include using contracts, budgeting, insurance, and training to
minimize potential losses from uncertain events. Risk management is a
straightforward process of identifying and planning, but this process can become
very complicated because of the many options available. Therefore, using a
framework or an outline to guide you through the maze of possible outcomes
greatly aids the strategic planning process. CORE Risk Analysis provides a guide
for an owner/operator to examine their management strategies.
This framework utilizes the acronym CORE. CORE stands for Calculate,
Optimize, Reduce, Evaluate. CORE highlights the importance of understanding risk
issues and their potential impacts on a business. The framework also engages
owner/operators in the exercise of examining the cost/benefit tradeoffs that
exist from competing strategies. The foundation of CORE is for producers to
realize the basic, fundamental importance of identifying and managing risk in
their operations. The framework presents a logical process for producers to
consider when examining ways to manage their business risks. CORE illustrates a
four-step process:
- Calculate your business risk.
- Optimize opportunities to address business perils.
- Reduce risky events using management tools/practices.
- Evaluate strategy/strategies with a risk management team.
Each step of the framework is a straightforward analysis. In addition, each
step requires specific action for the owner/operator to move to the next step.
Business risks, according to USDA’s Risk Management Agency, are broken down into
five different areas: production, marketing, financial, legal and human
resources. For additional reading on RMA risk management areas, refer to the
USDA publication, Introduction to Risk Management, Understanding Agricultural
Risks.
This fact sheet discusses in detail each of the steps in the CORE framework.
The framework begins by examining the specific perils that businesses face. Once
the adverse events/outcomes have been identified, an analysis of the costs and
benefits of possible options is assessed. The framework focuses on examining the
tradeoffs between various risk management activities. Listing each strategy that
addresses a specific peril allows for a cost/benefit analysis of specific
actions. Doing nothing can be a strategy, but a producer should realize the
implications (risk exposure) of that particular strategy. For risk management,
the optimal strategy is not always clear-cut. Many dynamics are involved, making
strategic risk planning an exercise that is unique to a specific producer and/or
business. These dynamics include risk attitude, a business’s risk capacity, cost
of implementing strategy, level of risk protection, probability of an outcome
and the severity of an outcome. Among these listed factors, the main dynamic at
play is the producer’s understanding and attitude toward risks. Therefore, the
next section discusses risk attitudes and definitions.
Definitions of Risk
Risk is defined as the chance of loss or an unfavorable outcome associated
with an event or action. Therefore, risk management refers to managing your
business against the chance of loss from an unfavorable event. An individual’s
risk attitude or preference is simply how one views risks. This attitude has the
biggest influence on a business’s risk management strategy. Risk attitudes
determine how an owner/operator views specific risks and the potential effects
of those risks on their business. Individual attitudes toward risk are generally
grouped into three different categories according to an owner/operator’s risk
preference:
Risk Averse – These are the most cautious risk takers. They avoid risk
whenever possible, but are willing to accept some risks. These individuals
usually miss out on profit opportunities by resisting or slowly adapting to
innovative products or practices.
Risk Neutral – They are realistic and try to minimize risk while pursuing
profit opportunities. They recognize that there is some level of risk in almost
every situation and understand the need to accept some level of risk.
Risk Loving – Risk excites and challenges these individuals. They enjoy the
“adventure” without taking risk-reducing precautions. They pursue the profit
opportunities that risky ventures present because they want to benefit from the
risk-return tradeoffs.
The important thing to note is that there is no right or wrong answer, only
different risk perceptions. These differences in perception make risk management
a very individualistic exercise. An owner/operator should spend some time to
identify which category they fall into regarding their risk management
personality. Understanding your risk attitude provides insight into an
owner/operator’s risk tolerance level as well as why selections of specific risk
strategies occur.
A good understanding of a business’s risk capacity is also needed. Risk
capacity refers to the ability of a business to survive an adverse event. In
other words, “how big of a hit can your business withstand?” The risk capacity
of a business can be measured by cash reserves, business equity, credit
reserves, lines of credit and alternative income sources. The important thing is
to understand your business’s risk capacity. This will assist in determining the
level of risk that you are willing and, more importantly, able to accept.
Other dynamics concerning risk management involve the probability and
severity of potential events creating losses. Probability is the likelihood or
odds that an event will occur. The higher the probability the more likely it is
that the outcome will occur. Probabilities have a value ranging from zero (0) to
one (1) but are usually expressed as a percentage. Severity refers to the
magnitude of the potential loss. Many risks are so small in magnitude that one
either ignores their potential effect or accepts the potential loss without
protective measures (self-insurance).
Before we get into the CORE framework discussions, a few risk management
concepts should be noted. Risk management involves comparing the cost and
benefits of reducing specific risks and selecting a specific risk management
tool. The following concepts (Partnership for Small Farm Risks, 2002) describe
the reality of the business environment in which owner/operators maneuver:
(1) Profits are never certain. Producers operate in an uncertain (risky)
environment where there is a risk-return tradeoff. Producers must choose between
risky alternatives, but higher risk activities should represent increased profit
opportunities.
(2) Using a risk-reducing alternative usually increases costs and/or reduces
potential returns, but the action should lower the uncertainty of those returns.
Risk protection comes at a cost, but the value of the added protection usually
results in a worthwhile investment.
(3) If two alternatives cost the same and produce the same returns, good
management seeks the alternative with the least risk.
Calculate Your Business Risk (Step 1)
The first step in this process involves identifying the different events
that affect or have the potential to affect your business. Because producers
face so many risks, they may wonder where to start in terms of identifying their
business risks. Two different ways to examine risky events is by the probability
of the event or by the severity of the potential loss. Both of these approaches
allow you to examine and categorize risky events. One operator may only be
interested in events that are likely to occur (high probability) whereas another
may only be concerned with severe or catastrophic events. Because the likelihood
and impact of an adverse event combine to create the total “risk” exposure, one
must consider risk across both of those dimensions, as illustrated below. This
approach allows one to rank possible outcomes, creating a pecking order of
potential events to address. Using this approach, high probability and high
severity events would obviously rise to the top of the risk areas that need
addressing. This process of ranking risks is very subjective and
individualistic, but the importance lies in applying the framework to meet your
business objectives and/or your acceptable risk exposure levels.
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Spectrum of Risky Events
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Severity/Consequence
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Probability
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| Low
| Medium
| High
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| Low
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| planning
| *high priority area
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| Medium
| planning
| adequate planning
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| High
| *high priority area (*requires risk management)
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Optimize Opportunities to Address Specific Perils (Step 2)
The next step involves identifying the different tools or practices that are
available to protect against each listed risky event that you wish to address.
Sometimes, the optimal choice for some events is self-insurance. This occurs
because some events are so small in either probability and/or severity that the
business’s risk capacity can absorb the shock. Other times, there are no risk
protecting options available or the cost of risk protection is so great that it
is optimal to maintain the risk exposure. The management process involves
identifying tools that address specific risk. A partial listing of risk
management tools available categorized by RMA’s risk areas follows:
- Production – irrigation, good production records, crop insurance,
enterprise diversification and variety selection.
- Marketing – marketing plans, production/ marketing contracts, futures
markets and storage/processing equipment.
- Financial – adequate record keeping, leasing vs. purchase, lines of credit
and maintain adequate cash/equity reserves.
- Legal – property and liability insurance, professional assistance and
specialized training.
- Human Resources – life/health insurance, employee training, safety training
and contracting for custom work.
Reduce the Adverse Effects of Specific Risks (Step 3)
Once the tools have been identified, examine the level of protection that
each alternative provides. Risk management involves calculating the costs and
benefits of a specific strategy and comparing the competing approaches.
Selecting a risk management strategy usually involves some cost, but the added
risk reducing benefit should outweigh the implementation costs. Careful analysis
of the potential impact of each alternative is necessary to understand which
strategy best fits your needs.
Cost-benefit analysis offers an easy way to evaluate competing strategies.
The analysis, as the name implies, details the corresponding costs and benefits
associated with a specific course of action. The brief outline below allows for
a quick cost-benefit analysis:
(1) Estimate costs of implementing each alternative.
(2) Estimate the benefits associated with each alternative.
(3) Examine how each alternative ranks by your selection criteria(s), i.e.
cost/returns, risk protection level, etc.
From this exercise, two important questions need to be answered: (a) which
alternative is more efficient based on estimated costs and returns, and (b) does
the strategy provide adequate risk protection for your business.
Evaluate the Effectiveness of Strategy (Step 4)
The final step before implementing a risk strategy is complete evaluation.
The evaluation process involves consulting with a risk management team to gather
feedback and advice on planned strategies. This team should be utilized
throughout the process of developing your risk plan. An owner/operator should
not feel like they are alone in the risk management process. Agricultural
producers wear many hats including production expert, human resource manager,
financial expert, chemical applicator, marketer, etc. Producers should seek the
advice of University and private business professionals to assist in the
development and initialization of their risk management plan. The following list
identifies some professionals to incorporate into your risk management team
along with their areas of expertise:
- University and Extension personnel – recommended production and management
practices, training opportunities
- Government agency personnel – government programs directed at business
development and assistance in the areas of start-up (business plans, marketing
plans, etc.), financing including grant funding opportunities, risk management,
cost sharing programs, regulations and certification requirements
- Financial planner – record keeping, establishing business goals, business
plan development, insurance recommendations
- Accountant – record keeping, tax issues, estate planning
- Lawyer – liability exposure for business, personal injury and environmental
regulations, business structure, estate planning, asset transfer
- Insurance agent – available insurance products and liability issues
The risk management process is complicated and the stakes are too high for
owner/operators to not rely on the advice of “experts” throughout the process.
It is important for owner/operators to identify key “advisors” to assist with
risk management throughout the process of setting business goals and objectives,
identifying effective risk management tools and successfully implementing
strategies.
Summary
CORE risk analysis is a four-step framework for analyzing business risk. The
framework focuses on identifying specific risks, understanding the cost/benefit
tradeoffs between alternative courses of action, and selecting the optimal
alternative for your business needs. The final step which is on-going requires
using expert assistant to evaluate the effectiveness of your risk plan. The
framework is as follows:
- Calculate your business risks.
- Optimize opportunities to address business perils.
- Reduce risky events using management tools/practices.
- Evaluate the strategy with a risk management team.
Although this report does not discuss the process of setting goals, the
framework should be used in the context of meeting specific business objectives.
The framework serves as a guide formalizing the mental process that
owner/operators undertake to address their business risk management needs.
Sources
The Partnership for Small Farm Risks: A Risk Management Education Project for
Small and Socially Disadvantaged Farmers. Risk Management Education. 2002.
USDA, Risk Management Agency. Introduction to Risk Management, Understanding
Agricultural Risks: Production, Marketing, Financial, Legal, Human Resources.
Revised December 1997.
Author:
Ronald Rainey, Ph.D., Extension Economist
DR. RONALD RAINEY is Extension economist with
the University of Arkansas Cooperative Extension Service in Little Rock.
FSA30-PD-10-03N
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