by Adam Juda on Thursday, January 2, 2020
I wish that more business owners would ask themselves a very simple question: "What will customers buy from me?"
Manufacturers often think in terms of products that roll off an assembly line. Service providers tend to focus on the labor that their employees perform.
Very few business owners, however, pay much attention to a source of value that they can provide: the acceptance of risk. A cornerstone of premium business models, risk acceptance is often considered little more than an esoteric footnote in even more esoteric business texts.
This is a problem that we need to correct.
Offering risk acceptance is a lot like selling insurance
Before we dive into the details, let's think about the typical definition of insurance. Most textbooks describe insurance policies as financial instruments used to limit catastrophic loss. In the context of this discussion, however, it would be more helpful to approach the definition from the perspective of the vendor rather than that of the buyer.
For those who sell insurance, such policies are a means of taking payments from a pool of customers and distributing a fraction of the revenues to a subset of those who paid in. Using this admittedly over-simplified definition, as long as the amount of money taken in is larger than the amount of money handed out, the insurance provider earns a profit.
Warranties, guarantees, and promises work in much the same way.
When vendors guarantee their offerings, they open themselves up to two sources of potential benefits.
- Increased pricing power - As risks are transferred from buyer to seller, customers will demand fewer discounts as a hedge against poor outcomes.
- Elevation of class - Risk acceptance can act as a strong source of product differentiation. Offerings from firms that guarantee their wares tend to be perceived as superior to those from vendors that utilize a caveat emptor approach.
What makes a "good" acceptance of risk?
Let's take a look at some of the characteristics of an ideal risk-acceptance opportunity:
- A high perceived likelihood of negative outcomes by shoppers - Without a belief that problems are likely to occur, buyers will be hesitant to pay for a hedge against risk. Many vendors will intentionally increase the perception of risk in order to increase the perceived value of their risk acceptance. The reasoning behind this is explained in my analysis of why no one offers coconut insurance.
- A high perceived magnitude of the consequence of risk by the shopper. The worse the perceived potential outcome in the event of failure, the more a buyer will be willing to pay to avoid or mitigate the risk.
- Minimal risk acceptance by competitors - When other vendors don't stand behind their offerings, the act of accepting risk will carry significant weight. On the other hand, should all vendors accept risk in a marketplace, the act of doing so may be less of an order qualifier than an order winner.
- High perceived internal costs for risk reduction by shoppers - When customers find themselves unwilling or unable to shoulder the cost associated with a risk, they will tend to look toward outsourcing risk acceptance. This is true even for cases in which the shoppers themselves could provide the product or service in question. This is an important advantage for those who deal in bulk as they can more easily reduce the expected costs of risk acceptance via economies of scale and scope. For instance, a firm may outsource the preparation of lunch for its employees, not because its staff can't cook food, but because catering companies are more able to deal with risks involving food safety.
- Lack of moral hazard - Sometimes buyers respond to the existence of a safety net by taking part in increasingly risky behaviors. In extreme cases, the availability of insurance may actually cause buyers to manifest the very outcomes that they insured against. For instance, there is often an increase in suspicious arson cases during real estate busts. Except for cases in which a negative outcome is clearly the result of vendor negligence, vendors should attempt to make their customers whole, but limit their remedies to no better than that - lest they create a moral hazard.
- A sufficient pool for risk - The larger the number of buyers, the more easily a vendor can estimate the likelihood and size of future claims.
- A strong belief that the vendor's promises will be honored - Such trust will likely be predicated upon two suppositions:
- The vendor will be able to follow through
- The vendor will be willing to follow through
- Knowledge that guarantees exist - Although one would think this point obvious, it must be stated explicitly. If customers are not aware of a vendor's guarantees before a purchase has been made, their buying behavior will not be affected. Such a case would represent the absolute worst outcome for a vendor - it would be required to assist the customer without having benefited prior to the sale.
Offering insurance to one's customers can be an inexpensive yet powerful means to boost credibility and pricing power. Business owners owe it to themselves to consider risk acceptance as both a competitive differentiator and a source of potential profit. There are few panaceas in the world of business, but this is about as close as it ever comes. The other one that is more obvious is. of course, contacting me for a consult.