THE ECONOMICS OF RISK MANAGEMENT

Risk management efforts must save more money than they cost if they are to be financially feasible. It does not make economic sense to spend $100 to prevent a risk whose occurrence will only cost $10. In most situations, it is cost effective to prevent injuries, but a decision to establish a costly quality control program should be backed up with proper economic analysis. As government regulations on health care providers are being loosened, most providers have begun to realize that the alternative of regulation through litigation can be much more costly than government regulation. This new litigation climate demands that providers quickly develop mechanisms to manage risks, lest they face catastrophic losses from unanticipated litigation.

There are three contributions to the cost of risk-taking behavior. The first is the direct cost of the occurrence of the risk. This includes the loss of skilled personnel time because of litigation as well as the payment of compensation to the injured patient. The second is the cost of the efforts to prevent or manage the risk before its occurrence. The third is the cost of the new risks that arise from the efforts to control the existing risks. An example of such newly created risks would be the complications that arise from medical laboratory tests that are ordered because of a fear of malpractice suits. It could be very difficult to defend a suit brought by a patient who is injured by a medically unnecessary test.

The cost of such new risks can be very important during the initial phase of a new quality control program. Their cost will be added to the cost of the claims that were incurred before the start of the new program but are being paid after the program starts. Once initial costs are absorbed, the cost of the quality control activities will be offset by the decreased losses due to the occurrence of existing risks. There will come a point of diminishing returns, however, where the costs of the quality control program will no longer be offset by the savings from the reduced incidence of existing risks.

To put the problem of diminishing returns into a mathematical shorthand, let CR represent the total cost of quality control activities, let CO represent type direct cost of quality control efforts, let CID represent the indirect cost of quality control activities due to the creation of new risks, and let L represent the total losses related to risks. The total losses L will equal the sum of the costs related to the occurrence of risks CO and the total cost of the efforts to prevent the risks CR: L = CO + CR. And the total cost of the efforts to prevent the risks CR will equal the money directly spent on quality control efforts CD, plus the costs due to the new risks that are created CID: CR = CD + CID.

When there are no expenditures for quality control efforts, neither will there be any indirect losses due to the creation of new risks. At this point, the cost of the occurrence of risks will be the total losses of the program. If it is assumed that quality control efforts will have some effect on reducing the costs due to the occurrence of risks, then the costs of the occurrence of existing risks should be at their maximum value when the expenditures for quality control activities are zero.

When a provider begins to spend money on quality control activities, the costs due to the occurrence of risks will decrease. This reduction will continue until all the preventable risks are eliminated, leaving only an irreducible baseline cost due to the occurrence of unpreventable risks. Because it is impossible to prevent all risks, the costs due to the occurrence of risks can be reduced only to this baseline level. At the same time that the increased expenditures for quality control efforts are reducing the costs due to the occurrence of risks, the costs due to the occurrence of new risks created by the quality control efforts will be increasing. Since the total cost of the quality control program will always be greater than the budgeted expenditures.

The relationships imply that the costs resulting from the occurrence of risks are inversely related to the total costs resulting from the occurrence of risks are inversely related to the total cost of the quality control efforts. This inverse relationship holds to the point where the costs due to the occurrence of risks have been reduced to their minimum level. Once this minimum level has been reached, further expenditures for quality control activities will not reduce the costs due to the occurrence of risks. If the total costs of quality control activities CR are plotted against the costs due to the occurrence of risks CO, with K representing the minimum cost of existing risks, then a graph resembling that in Figure2-1 will be obtained. It is important to remember that it is only the basic type of the curve that is important. It is impossible to establish a value for any of the points along the curve without actual data on the costs and benefits of the particular quality control system under study.

Since the total losses related to risks are equal to the sum of the costs due to the occurrence of risks (both new and old) and the cost of the quality control activities, the curve illustrates that there will be a point at which it is not cost-effective to spend more money on quality control activities. Once this point is reached, the added expenditures will not result in a corresponding decrease in the losses due to the occurrence of risks. This is the optimal operating point for a quality control program, and it can only be recognized by careful analysis of the decrease in the costs due to the occurrence of risks for each increase in direct quality control expenditures.

• The Classification of Risk
• Prevented Risks
• Normally Prevented Risks
• Managed Risks
• Unprevented Risks
• Unpreventable Risks
• The Duty to Act