In business risk is treated as a cost. Once in the business one has to bear this cost. Since, risk is associated with the activity it cannot be eliminated so long the activity is carried out. It, however, can be managed i.e., can be reduced or minimized but at a certain cost.
Risk management, therefore, implies minimization of income loss either by reducing variations in output or ensuring certain minimum price or guaranteeing certain level of income. It is a process of appraising and reducing risk. The ways devised to do so are referred to as risk management alternatives. These are discussed under the following heads.
1. Avoiding Risk
Some of the production risks can simply be avoided. For instance, eliminating more risky enterprises would minimize risk but at the cost of decreased total production (returns).
Laggards always try to avoid risk. They opt for assured though low income enterprises.
2. Preventing Risk
Many a time some risks could be prevented by taking advance action. For instance, risk of loss in crop yield due to pest attack could be prevented by following preventive pest control. The cost of this risk management alternative is the cost of preventive pest control.
3. Sharing Risk
This alternative of risk management is quite common in India. Important example of risk sharing is the share lease of land to tenants.
The production risks are shared between the landlord and the tenant in the ratio they share some inputs and the output.
The cost of this alternative to the landowner would be equal to the difference between the net income tenant earns less the cash rent he would have paid for rental lease.
4. Transferring Risk
Risk may be transferred from one entity to another. For instance, marketing risk could be transferred to buyers by way of forward contract. It guarantees to pay an agreed price for the produce to be realized in future.
The cost of this alternative is the difference in value of output at post-harvest/market price less the value realized at the agreed price.
Crop insurance is another example of transferring production risk to another entity i.e., insurance company. In case the crop prospects are reduced below certain minimum, proportionate indemnity is paid for the expenditure incurred. The cost of this alternative is the premium paid by the farmer.
5. Spreading Risk
Risk may be spread over a number of enterprises with varying degree of risk and of course with varying level of net income. This is known as diversification. Diversification could be in terms of mixed farming, diversified farming or even mixed cropping. The idea is not to put all eggs in one basket. It would ensure some income realization from enterprises/crops even in the event of adverse weather conditions etc.
As net returns from combination of different enterprises/crops would be less than the net returns from the most paying crop (pure) the differe5e between the two would be the cost of this alternative.
6. Taking Risk
Taking risk could be one of the alternatives to manage risk where the management cost is nil because no attempt is made to reduce risk. The idea is to plan for maximum returns even at high risk.
Innovators and early adopters are the two categories of people who always are willing to take risk. They go for high return enterprises exposing themselves to high risk.