The potential for losses seems to be around every corner in the cannabis industry. What you do to mitigate the risk and protect your investment could be vital for the survival of your business.
By Brenda Wells
Risk is simply the uncertainty regarding outcomes. We see it in gambling — whether you are spinning the roulette wheel or waiting on the blackjack dealer to turn over a particular card, there is an element of uncertainty present.
Gambling is a voluntary activity that you can avoid if you so choose, but in the cannabis business there are risks you simply cannot prevent. These include damage to your facility and crop, injuries to your employees, lawsuits from someone who claims to have been injured by your products, and theft of your cash proceeds. Thus, it is important for every cannabis businessperson to understand and engage in proper risk management.
Risk management is the process of identifying the risks you face, and developing a plan to survive them. There are four steps in the risk management process. They are:
– Identify the risks you face. (Circumstances that can result in a loss are called “loss exposures.”)
– Analyze those loss exposures in terms of frequency and severity.
– Select appropriate techniques for treating each loss exposure. Available techniques include risk control and risk financing.
– Implement and monitor the risk management program.
Identify Loss Exposures
Risk identification is usually considered to be the most challenging phase of the risk management process. Identifying all the risks of loss a cannabis business may face is a daunting task that is almost never truly complete — there is always something new developing that can cause a loss.
It is important to be vigilant in the area of loss exposure identification so that you stay keenly aware of all the things that might ultimately cause you to suffer a loss.
Analyze Loss Exposures
When analyzing loss exposures, two important dimensions of concern are frequency and severity. Frequency is how often something might occur, and severity is how serious and costly it might be if it does happen. It is vital to never underestimate the frequency or severity of loss.
I recently watched “High Profits,” a reality show about Breckenridge, Colorado’s cannabis business. I was genuinely shocked at how the main character in the series seemed to, in my opinion, seriously underestimate the risk of his employees being robbed. The risk involved with transporting cash should never be taken lightly. Some robbers will not hesitate to injure or kill somebody. It doesn’t matter how safe your town appears to be.
In analyzing frequency, you need to assume that every risk of loss can happen. Do not fall into the all-too-human mistake of thinking, “That won’t happen to me.”
In terms of severity, the cannabis business is new and somewhat fragile. It is in its infancy compared to most businesses, and its future is going to be determined by several things that are out of your control, such as legislation, regulation and elections. How are you going to survive if these events don’t turn out the way you hope they will? Have you thought about worst-case scenarios? If not, you need to start thinking about them today.
Risk Management techniques
Risk management techniques are divided into two categories: risk control and risk financing.
Risk control techniques serve to reduce or eliminate loss frequency and severity. Risk financing techniques pay for losses that ultimately occur.
– Risk control: Risk control techniques consist of avoidance and loss control. Avoidance means completely avoiding the activity, making the probability of loss zero. As Figure 1 shows, this is the optimal solution when a loss exposure is high in both frequency and severity. Unfortunately, many risks simply cannot be eliminated if you’re going to operate a cannabis business. When a loss exposure can’t be avoided, it is important to practice loss control.
Loss control consists of two separate activities: loss prevention and loss reduction. Prevention focuses on reducing the frequency of losses. Reduction is the minimization of loss severity.
Most techniques focus on either frequency or severity, but some methods serve to reduce both. These are the best solutions for losses that are high frequency, but low severity in nature. Risk control is desirable any time its benefits outweigh its costs.
Let’s take the loss exposure of robbery of your employees who are transporting cash. How can this be prevented? Where legal, the use of an armed guard is probably the most cost-effective method. While it does not completely eliminate the risk of loss, it does serve to deter would-be robbers. Another technique to consider is limiting how much cash you accumulate at any one time before transporting it to a safe location. If you only have $20,000 on hand, that’s all that can be taken from you if a robbery does occur. It’s much easier to absorb a $20,000 loss than it is to absorb a $100,000 loss.
– Risk financing: Risk financing techniques serve to pay the financial consequences of losses that occur. There are three such techniques: loss retention, insurance transfer and non-insurance transfer.
Loss retention means to retain or pay for the consequences in-house. If you don’t have insurance, and have not found another way to pay for losses, this is the method you have chosen by default.
An insurance transfer involves the purchase of an insurance policy to which the financial consequences of covered losses are ceded. This is the optimal risk management solution for loss exposures that do not occur often, but have the potential to be very severe when they do occur. There are insurance firms that specialize in serving the cannabis industry. If you haven’t contacted one yet, put that at the top of your to-do list.
Non-insurance transfers are other types of contractual transfers, such as hold-harmless agreements, waivers and incorporation. Incorporation is one of the most basic and fundamentally important non-insurance transfers available to you. Did you know that if you’re not incorporated and someone sues you, they can ultimately seize your car, your home and your savings? It’s important to have a properly-structured corporation to protect your personal assets.
The right methods
The selection of the appropriate technique for handling a given risk hinges upon the analysis of frequency and severity.
If a loss exposure is relatively infrequent and minor in terms of costs, it is best to retain that loss by managing it in-house and paying for any consequences. If frequency becomes elevated, it is still best to retain those losses, and to practice loss control to reduce frequency.
If a loss exposure is high severity in nature and can occur frequently, avoidance is the recommended solution.
Insurance, when it is available, is best for losses that occur infrequently but have high loss severity potential. As mentioned previously, this is a critical tool to protect your financial investments.
Implement the plan
So you’ve given some thought to risk management, and you’ve decided to create a risk management plan of your own. Do you need to get your business incorporated? Do you need to find out what it will cost to insure your business?
You are ultimately retaining all the risks of loss until you put the plan into action and arrange the details. Once a plan is in place, it’s important to monitor the environment around you to remain aware of what new types of risks are developing that may impact your cannabis business.
Brenda Wells is the Robert F. Bird Distinguished Scholar of Risk and Insurance at East Carolina University. During her career she has taught insurance courses that include commercial liability, commercial property and insurer operations. She has published articles on the risk management implications of cannabis legalization and is a sought-after expert in the risk management and insurance field. She can be contacted at firstname.lastname@example.org with questions or topics for future articles.