Whether in business or in personal life, people only partner up when each has something that the other wants. You both bring something different to the table—and, as a result of the partnership, you and your partner are better off.
Basic, right? Well, one of the beneficial but under-appreciated differences someone can bring to a partnership is the ability to bear risk: some people or companies are in a better position to take on the prospect of bad outcomes than others. (Middleman businesses of all sorts are often in this position, since they typically deal with a full portfolio of sellers; accordingly, playing this Risk Bearer role is one of the six ways middlemen create value.)
Most economic outcomes are some combination of internal factors and external ones. The Risk Bearer must correctly distinguish between the two.
Understanding how the risk-bearing process works helps you be more bold without being foolish—and can prevent the frustration faced by people who don’t understand the logic of risk-sharing partnerships.
The example of insurance
The classic example of this kind of partnership is the relationship between a reputable insurance company and each of its policy holders. The insurer’s vast number of policyholders enables it to pool and diversify away a lot of risk; in addition, the insurer’s actuarial acumen enables it to price its policies according to each subscriber’s risk profile—such that safe drivers, for example, pay less than accident-prone drivers do.
Policy holders also benefit: the whole point of the insurance contract is to ensure that an accident won’t cause financial ruin. (That’s the hope anyway, since the insurance industry is, unfortunately, notorious for weaseling out of claims.)
In general when the party that’s best able to bear the risk does so, both parties are better off.
A curious irony?
All sorts of businesses—not just insurance companies—are often in the ideal position to bear risk. In fact, it seems they would embrace it, since they can profit from attracting trading partners who are afraid of risk. So why does it often seem that so many companies avoid risk?
Consider the following cases:
- A single mother struggling to keep up with mortgage payments on her condo tries to refinance, but the lender rejects her application because she had recently lost her job, which is the very reason she is struggling. On the other hand, Mark Zuckerberg refinances the loan on his $5.95 million mansion and gets an interest rate of 1.05 percent, less than half the national average at the time.
- A 50-year-old man gets advanced-stage prostate cancer, begins aggressive treatment, and applies for life insurance to protect his family if he should die. The insurance company turns him down, telling him he can apply again in 12 months. Meanwhile, the same insurance company advertises to young families, eager to sell them policies with low monthly premiums.
- An aspiring children’s book author who’s never been published before wants to reach a wide audience, so she sends her manuscript to a literary agent specializing in this market, but he ignores the submission completely. Meanwhile, a movie star with a first manuscript has agents vying to get her a book deal.
Do you see the pattern? It seems like the people who least need help are the only ones able to get it.
But despite the apparent absurdity of all these situations, to me they make perfect sense. The key to understanding the logic is to recognize that there are two kinds of risk. If the Risk Bearer is running a for-profit business rather than a charity, they should avoid one kind of risk and embrace the other.
The two kinds of risk: external and internal
To begin to see what I mean by two kinds of risk—the one that middlemen should avoid and the one they are wise to embrace—start with the following truth: most economic outcomes in the world are some combination of skill and luck (or effort and chance, or internal factors and external ones).
How many widgets a sales rep sells, for example, depends on how hard the rep works (effort), how good the rep is at sales to begin with (skill), and factors completely outside the rep’s control, from the quality of the competition’s widgets to the state of the economy (external factors).
The rep shouldn’t be held responsible for those external risks, and the company she works for (which has many reps and deeper pockets than each rep does) is in a better position to bear the risk. The employer is a natural Risk Bearer here. But hold on a minute: what does that mean in practice—should the company pay all sales reps a fixed wage, no matter how many widgets they sell?
Usually not. To do that would make life less risky for the salespeople—but think of what that would that do to the reps’ incentives, to their skill and their effort. A fixed-pay scheme is likely to disproportionately attract lousy salespeople (because better salespeople would gravitate toward pay-for-performance employers) and may induce even the skilled reps to work less hard. So taking on all risk is a mistake because it includes taking on the wrong kind of risk—what I call internal risk (or what academics call counterparty risk or endogenous risk).
That’s why it makes perfect sense for a lender to be wary of lending money to someone with no job and no assets, no matter how much they want or need the loan. It is also why the insurance company and the literary agent did exactly what they did. First, they avoided the risk of partnering with someone posing undesirable internal risk—someone known to be a bad bet. Second, these businesses embraced external risk (technically called exogenous risk or force majeure), which is risk that isoutside both parties’ control, but which the Risk Bearer is in a good position to bear.
For example, no one knows which particular children’s book will become a hit, but on average books by movie stars outsell equally good books by unknown authors. However, exceptionally good books by unknown authors have a real chance of outselling unremarkable books by celebrities, so agent and publisher are wise to add those to the mix. The Risk Bearer must know how to distinguish between internal risks and external ones.
If you can afford to take a portfolio approach, you’re in a great position to play the role of Risk Bearer. To play the role well, though, you must avoid internal risk. There’s strength in numbers—but only if those numbers aren’t already known to be bad bets.
Where to read more
This article was originally published on LinkedIn and is reproduced here with the author’s permission. Follow Marina on LinkedIn or subscribe to her newsletter if you don’t want to miss a future article. She’s happy to hear from readers.
- The Risk Bearer: Embracing the Right Kind of Uncertainty - February 5, 2020