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Tel: +44 (0)1780 721664   Email: enquiries@qualitar.co.uk The Price of Risk June 2003 Recently, whilst advising a client, I got into a discussion about risk and the relative issues in transferring more risk from them to a supplier. The client I was talking to wanted to do this to reduce the commercial impact on their organisation if a particular risk did occur. I got the feeling they thought they could do this without the supplier increasing the price to them when they said "We’re a big customer – all suppliers want our business. They’ll just have to accept the extra risk if they still want our business." As my client had been happy to manage these risks for many years it was quite obvious that they now expected them to be more likely to happen than before. Now I don’t know about you, but it’s daft to think good suppliers will happily accept the likely possibility of incurring higher costs for the same amount of business without charging for it. Customers should remember that good suppliers can and will choose whom they provide a service to. It was at this point I felt I needed to explain the concept of risk having a price. To do this I used interest rates as an example. Interest rates are calculated according to the level of: Inflation Liquidity Risk Everybody knows that people who have a poor credit rating pay a higher interest rate for loans. That is, it costs them more to buy money because there is a higher risk they will not pay it back. People with a higher credit rating pay lower interest rates. Therefore the price of money (the interest rate) depends, in part, on the risk the seller perceives they are taking in selling money to a specific individual or organisation. Over the next few weeks my client found out that the cost to switch to another supplier was too high and that their current supplier was going to charge them more for the extra risks they were now managing. On my next visit I suggested that they should view the supplier’s risk adjusted price in a similar way to the interest rate example I’d used. I said they should view the supplier’s new price as being determined using the following key components: Cost Profit Inflation (sometimes) Risk premium After doing this my client turned to me and asked, "So what is the price of risk in this situation then?" Before I could stop out it came . . . "Ahhhhh well it depends." And then I started "The risk premium the supplier will charge will depend on how accurately they can assess the probability of a risk happening and the cost to them if it does. It also depends on their attitude to risk, as some are prepared to take more risks than others. The difference in a supplier’s attitudes to risk often depends on their current and expected trading performance, and the current and expected economic climate for the duration of the contract." "Well thanks for that but what can I actually do about it. I can see why my supplier wants to charge me more but the budget won’t cover it all." So now we are in a position where my client can’t afford to switch suppliers and can’t afford to pay the higher price. As I mentioned before, for the supplier to accurately price the risk they must have a good understanding of the probability the risk will happen and / or the impact if it does. However, let us assume that the supplier doesn’t have this understanding and is just guessing. Why don’t you.... Work with the supplier to jointly assess each risk event in terms of the probability that it is likely to happen and the impact if it does Use this to multiply the percentage probability by the overall cost of the risk if it happens to determine a nominal cost for the ris Put all this into a risk register and decide which party is more able to manage each specific risk event Decide what actions each party can take to reduce the probability of the risk happening and / or the impact if it does (don’t forget the cost of any actions taken to reduce risk) Re-calculate the nominal cost of each risk event to the organisation managing it based on the reduced probability and impact Use the nominal costs likely to be incurred by the supplier as the basis for increasing or decreasing their risk premium and total price After a little prompting the supplier and client agreed to review all the risks that could happen, not just the ones the client wanted to transfer and including those risks the supplier had been managing for many years.The result was that I facilitated my client and the supplier working more closely together to: Reduce the overall cost of the service by actually reducing the risk premium the supplier was charging Maintain the supplier’s actual profit level in pounds and not percentages Raise several other issues, now incorporated into an improvement plan, that are likely to result in slightly lower costs but with a significant increase in quality. Written by Mark Allen Qualitar Consulting Ltd © Qualitar Consulting Limited. All rights reserved. If you share these tips with others please always include our copyright and say they came from Qualitar. If you would like more information on the results we can deliver and the services we provide please e-mail us at enquiries@qualitar.co.uk   © Qualitar Consulting Limited. All rights reserved. Designed by apperleydesign.co.uk