Categorizing Costs

There are costs associated with risk and loss, some components of which are more measurable than others. In developing a framework with which to measure and predict these costs it is useful to allocate them as follows:

Risk Transfer Costs: Insurance is the most common way in which organizations transfer operational risks. Various hedging strategies are used to transfer certain forms of financial risk. For example, a firm with a significant exposure to foreign currency rate volatility may choose to purchase various currency related options in an effort to offset the negative impacts of changes in exchange rates.

Risk Mitigation Costs: Organizations undertake, at a cost, a variety of programs in an effort to reduce the probability of a negative event occurrence and thus reduce the risk profile in a given area. There are three general components of most risk mitigation plans in regards to employees: training, job/equipment design, and employee selection.

Direct Loss Costs: When negative events do occur, there are often direct costs related to them, costs not covered by insurance payments. An example would be the deductible a company has to pay in order to cover the first dollars of cost for repair incurred due to an accident.

Indirect Loss Costs: Incidents related to operational risks often impose indirect costs far beyond those that are directly attributable to the incident itself. For example, after a work related accident, an employee’s absence requires that other employees work overtime to cover for the reduction in capacity. The cost of overtime would be an indirect cost related to the injured employee’s accident.