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  Alex Dali December 21, 2010 20:13

  A letter of Credit is not risk reduction but risk financing !
  
  jacob szafranski said:

  Substitution is the simpler of the two. Instead of taking the risk of your direct counterpart you ask them to post a Letter of Credit, provide parent or corporate guarantee. The result would be substituting and accepting the risk profile of a third party. Eliminating may be tantamount to taking a lender out of a subordinated position. There are instances that other lenders are in a senior position to you (perfecting UCC filings, collateral etc...). Eliminating this risk would require entering into an intercreditor agreement which puts all the lenders in the same position. Thereby sharing the collateral, proceeds etc..
  Would like to hear your ideas/thoughts as well.
  Thanks
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  Sergey Utkin December 21, 2010 19:57

  What a question? If you eliminate - you destroy the risk source, if you substitute - not. Examples (for banks) - in 1st case you make a true sale of toxic assets to SPV (for example, sorry for tautology), in 2nd case you make a not true sale (like a factoring deal).
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  Alex Dali December 21, 2010 19:54

  This is also a good explanation...Thanks for sharing, David and Happy New Year 2011 to you. Alex
  
  David L Russell, PE said:

  I'll offer a bit of an explanation.  I'm sure others may disagree.

  The concept of risk relates to the concept of vulnerability. If there is no vulnerability, the risk is non-existent. I'll talk in terms of vulnerability reduction and substitution because the definition of risk is anthromorphic

  You can eliminate vulnerability by moving a facility or massively over designing the facility to withstand both external and internal vulnerabilities.  Consider:  Relocate the refinery inland to eliminate the risk from hurricane damage and the vulnerability from the same.  But you may introduce a vulnerability to damage from earthquake or prairie fire or forest fire or airplane crash.

  In that regard, there is no such thing as a facility with "no risk" or no vulnerability. When we attempt to make things foolproof, nature invents a better class of fool.

  Vulnerability by substitution can occur through use of such things as intrinsic safe design or chemical substitution which eliminates certain classes of vulnerability from explosion or toxic formations because the chemistry is different.  (Consider what might have happened at Bophal if Union Carbide had not been using MIC for the reactions.

  So: To summarize:  Vulnerability elimination occurs with specific actions and reduces certain types of vulnerabilities - through relocation or redesign.  Vulnerability substitution occurs when one makes changes in the type of operation to change the basic process to eliminate one or more types of vulnerabilities from specifi sources while producing the same products.

  Hope that helps.

   
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  Bill Ford December 21, 2010 19:44

  For static risk the following may illustrate. Selling a building eliminates the risk of loss by fire to the building. That is risk elimination. Risk substitution involves an exchange. Exchanging a frame building for a fire resistive building is risk substitution for loss by fire.

   

  For  dynamic risk ending the for profit activity is risk elimination. Changing the for profit activity is risk substitution. Investing in T bills instead of mortgage tranches is risk substitution. Ending all for profit activity and closing the company is an example of dynamic risk elimination.
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  Alex Dali December 21, 2010 19:10

  Dear Annus,

   

  First : Vocabulary. In risk management like in any field, the first step is to define a vocabulary for everyone to use. A good start would be to use the ISO guide 73:2009 which defines about 53 terms linked to risk management.

  If you want to modify a particular risk, ISO guide 73 proposes risk treatment. Risk treatment can involve:

  • avoiding the risk by deciding not to start or continue with the activity that gives rise to the risk;
  • taking or increasing risk in order to pursue an opportunity;
  • removing the risk source;
  • changing the likelihood;
  • changing the consequences;

   

  You can for example define risk treatment = risk reduction and/or risk financing with

  Risk reduction can involve:

  • avoiding the risk by deciding not to start or continue with the activity that gives rise to the risk;
  • taking or increasing risk in order to pursue an opportunity;
  • removing the risk source;
  • reducing the likelihood;
  • reducing the consequences;
  • contractual transfer for risk control (subcontracting)

  Risk financing can involve:

  • contractual transfer for risk financing = sharing the risk with another party or parties;
  • risk retention = retaining the risk (usually by informed choice)

  You go further

  Risk reduction can involve:

  • risk avoidance = avoiding the risk by deciding not to start or continue with the activity that gives rise to the risk;
  • risk elimination = removing the risk source;
  • risk prevention = reducing the likelihood;
  • risk protection = reducing the consequences;
  • contractual transfer for risk control (subcontracting)

   

  Second : Aspects of risk reduction.

  There are 3 important aspects in any risk reduction measure.

   

  1.       Action on the danger. Risk reduction focus on actual harm, on actual danger, on a particular risk, not on the money paid, which is the concern of risk financing. For example, when a car has an accident, the severity of the loss is not reduced because the owner of the car or the family of the injured receive financial compensation for the loss. Risk financing techniques are not risk control techniques.

  2.       Action to an entity. Risk reduction can be measured only from the perspective of a given entity. For example, spray applications of paints create several hazards such as fire hazard because many solvents and paints are flammable and health hazard because many solvents and paints are toxic. If you impose the painter to wear a personal protective devices (respirators), this risk reduction measure reduce the health hazard (the danger) to the painter (the entity), but does not reduce the fire hazard (another danger) to workers of the factory (another entity). A more efficient risk reduction measure would be to replace the paints or solvents by another one – non flammable, non toxic substance.

  3.       Efficiency of an action. The efficiency of any risk reduction measure should evaluated. The level of risk should be evaluated before and after the measure. However, please remember that a measure to control one kind of loss could increase the frequency or severity of other losses. Therefore, any risk reduction measure should reduce the aggregate level of risk.

   

  In summary, risk elimination can be used is if one (or several) particular hazard disappears for one (or several) entity. Risk substitution can be used if you “removing the source of risk introduces new thing which has less or no risk as previous” linked to a particular hazard exposing a particular entity.

   

  Third : Risk management curriculum.

  A final note :

  If you are involved in risk management, I would advise you to take a formal international recognized curriculum on risk management fundamentals such as ARM diploma proposed by the Institutes (USA) or the Institute of Risk Management (UK). Both have been adapted with the new ISO 31000 risk management standard. Nobody can become an accountant by participating in congresses and seminars. The same applies to risk management. Unfortunately, many risk management professionals have no educational curriculum in risk management. This is a sad situation.... Let's have hope for 2011. Happy New Year 2011 !
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  jacob szafranski December 21, 2010 18:36

  Nagesh, well put. You hit the nail on the head. It is not a matter of substitution or elimination, as you said its management. If you are not prepared to take risk, you should not play.
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  jacob szafranski December 21, 2010 18:32

  
  
  Nagesh Bharadwaj said:

  There is nothing called "Risk Elimination".  Any risk management practioner will tell you that Risk cannot be eliminated.  As a matter of opinion, risk need not be eliminated.  If there were no risk in an activity then the activity would not be that profitable after all.  It is your "beta" from the investment lingo.  Another way to look at it is not taking a preceived risk is also a risk in itself.

  The operating parameter then is that you want to manage risk so that it is at a tolerable level or it will be as expected delivering close to the results you expect in your activity.

   

  Having said that, the discussion of whether something is risk elimination or risk substitution is mere theoritical, you can perceive the way you chose to, I guess.

   
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  Anatoly December 21, 2010 18:31

  If the risk that remains is not what it was, then this elimination with replacement.
  For example, a fixed fuzzy instructions, eliminating the risk of unwanted eventsprescribed by this instruction and there was risk of default on the new instructions.
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  Nagesh Bharadwaj December 21, 2010 18:17

  There is nothing called "Risk Elimination".  Any risk management practioner will tell you that Risk cannot be eliminated.  As a matter of opinion, risk need not be eliminated.  If there were no risk in an activity then the activity would not be that profitable after all.  It is your "beta" from the investment lingo.  Another way to look at it is not taking a preceived risk is also a risk in itself.

  The operating parameter then is that you want to manage risk so that it is at a tolerable level or it will be as expected delivering close to the results you expect in your activity.

   

  Having said that, the discussion of whether something is risk elimination or risk substitution is mere theoritical, you can perceive the way you chose to, I guess.

   
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  Edward Collins December 21, 2010 18:11

  Annus, to my mind there is no such thing as risk elimination. I think you're very smart to describe the process as risk substitution, which I interpret as trading an unacceptable risk for an acceptable risk.

   

  As for practical examples: examination of counterparties through background checks and financial evaluations before doing business with them; hedging against fluctuations in the value of commodities essential to your business; avoidance of geographic or political risks which may be volatile or unexpected;  consideration of competive advantages or disadvantages by experienced individuals, including outsiders, before making major business commitments; rigorous internal controls to prevent dominance of any one individual or group in making important business decisions without due diligence; and finally, consideration of the old adage "If it looks too good to be true it probably is".

   

  In practical terms this means fearless risk assessment and application of same.