Table of Contents
- What is risk management?
- Why is risk management important?
- Risk management processes and framework
- Methods of risk management
- Other risk management strategies
- FAQs on Risk Management
What is risk management?
Risk management refers to the act of identifying, assessing, and controlling the threats to the capital and earnings of an organization. These risk factors can emerge from various sources including financial uncertainties, issues of technology, legal liabilities, errors in strategic management, natural disasters, accidents, etc.
Any organization that is able to successfully manage its risks can consider the complete range of risks it faces. Risk management also helps in examining the relationship that exists between risks and the effects they are bound to have on the strategic goals of an organization. Risk management takes place all over the world in the financial realm. It occurs in investment and business decisions.
There are severe consequences that companies, individuals, and the economy bear when they fail to adequately manage their risks. It is common for laymen to look at risk in negative terms. However, the risk is necessary in the investment world and one cannot separate it from desirable performance. When we define investment risk, it is commonly a deviation from an expected outcome and we can express this deviation either in absolute or relative terms to something else such as a market benchmark. As this deviation is bound to be either positive or negative, professionals of investment generally accept the idea that such deviations are the implication of some degree of intended outcome for an individual’s investments.
Thus, for one to achieve higher returns, one is expected to accept the greater risk. It is also a generally accepted idea that an increase in risk comes in the form of an increase in volatility. While investors constantly look towards ways of reducing such volatility as well as finding them occasionally, a clear agreement does not exist among them on the best way of doing it. The amount of volatility that an investor should accept is entirely dependent upon the risk tolerance of the individual investor. In the case of an investment professional, it is dependent upon the level or amount of tolerance their investment objectives permit.
Enterprise risk management (ERM)
The holistic approach towards the management of risks is sometimes referred to as enterprise risk management. This is because it emphasizes the anticipation and understanding of risk across an organization. In addition to focusing on internal and external threats, enterprise risk management lays emphasis on the importance of managing positive risks.
What then are positive risks? These are opportunities that are bound to increase the value of a business or on the other hand, have a damaging effect on the organization if it fails to take these opportunities. Certainly, the objective of risk management is to eradicate every risk and on the other hand, add to the value of the enterprise by making smart decisions with regard to risks.
Alla Valante, Forrester Research senior analyst and a specialist in governance, risk, and compliance said, “We don’t manage risks so we can have no risk. The essence of managing risks is to know whether they are worth taking or not. Some risks can help an organization arrive at its goals and objectives as well as its payouts.
So, it is necessary for a risk management program to be carried out alongside organizational strategy. In other words, one should not separate these two actions from each other. In order to link them, it is necessary for risk management leaders to first define the risk appetite of the organization. That is the level of risk an organization is willing to accept to realize its objectives. So it is necessary to achieve the tasks of determining the risks that fit into the risk appetite of the organization and those risks that require additional actions and control before they become acceptable. Risks are inevitable in every facet of our lives.
According to Notre Dame in his article risk appetite vs risk tolerance, some risks will be accepted without necessarily taking further actions. While others have to be mitigated or transferred to another entity/party or avoided altogether. Every organization faces risks of unexpected and hazardous events that are bound to involve financial costs or even bring about its closure. The risk an organization undertakes can also spell trouble.
There are various tactics that exist in order to ascertain risks and the standard deviation is one of the most common tactics. This is a statistical measure of dispersion around a measure of central tendency.
Beta is a measure of market volatility which is also known as market risk or systematic risk of an individual stock when comparing it to the entire market.
Alpha refers to the measure of surplus return. Managers of finance who adopt active strategies to beat the market are usually exposed to alpha risk.
Enterprise risk management, therefore, has to do with the environmental, operational, regulatory, financial, regulatory market, and other risks that have an impact on large enterprises as well as their outlook and planning.
Why is risk management important?
Risk management is important because it shows businesses the threats that surround them in their operations which helps them to mitigate risks. If this mechanism is absent, businesses will incur huge losses as several risks will blindside them. Through risk management, businesses are being empowered with the necessary tools for identifying and dealing with potential risks. It is easy for a business to mitigate the risks that surround it once identified. It is through risk management that organizations have the basis of undertaking sound decision-making.
The act of assessing and managing risks is helpful in the business setting. With this businesses will be able to prepare for the events that are bound to happen. This helps in facilitating organizational growth and success. A business is successful when it evaluates its plans for dealing with potential threats as well as developing structures that will help to address them.
Also, an entity that progressively manages its risks will deal with high-priority risks as aggressively as possible. In this case, there will be necessary information available that aids the management of an organization to make informed decisions to ensure its continuous profitability.
Risk management processes and framework
The risk management process shows the framework of actions that an entity needs to take. There are five basic steps that are necessary to take while managing risks namely;
- Identify the risk
- Analyze the risk
- Risk evaluation and ranking
- Treat the risk
- Monitor and review the risk
Identify the risk
The first step to managing risk is to identify the risk exposure of the organization within its operating environment. Several types of risks exist in an environment such as legal risks, market risks, regulatory risks, environmental risks, etc. It is critical for an organization to be able to identify these risks, as many as possible. In a manual environment, a risk manager can note these risks down manually. If the organization then employs the risk management solution that it has, it will as well insert all the information directly into the system. This approach has great advantages attached to it because the risk exposures become very visible to every stakeholder in the organization that has access to the system. This makes it easier to have access to information in the system rather than having to go through emails to request information regarding risk exposures.
Analyze the risk (risk analysis)
It is necessary for one to analyze risk after identifying it, that is risk analysis. It is critical for the risk manager to determine the scope of the risk. One should also be able to identify and understand the link that exists between the risk and various factors within the organization. For the risk manager to be able to determine the severity and seriousness of the risk, he has to take a look at the number of business functions the risk affects. These are risks that have the capacity to bring the entire business to a standstill if actualized. There are also risks that will only pose minor inconveniences in the analysis. As earlier stated, in a manual risk environment, one has to do this manually. In the implementation of risk management, some basic steps are important. One of these basic steps is to map risks to different documents, policies, procedures, and business processes. This implies that the system will already have a mapped risk framework that will help you in evaluating those risks and show you the extent of the effects of each risk.
Risk evaluation and ranking
It is important for one to evaluate, rank, and prioritize risks. Most solutions to risk management problems have various categories of risks depending on the severity of the risk. Risk managers rate risks that may bring about some inconveniences as low. On the other hand, risks that can bring about a catastrophic loss, risk managers rate them as the highest. When an organization ranks its risk exposures, it will have a holistic view of the risks that surround the organization. An organization may be vulnerable to so many risks that are of low level, however, it may not require upper management intervention. Conversely, a single risk that is rated as highest is enough to call for an immediate and upper management intervention.
Treat the risk
There is a need to eliminate or curtail every risk as much as possible. An organization can do this by connecting with experts in the field. This takes place by connecting with experts in the field under which the risk falls. In a manual risk environment, an organization has to contact each stakeholder and then hold meetings for everyone to talk and discuss the issues. The challenge here is that the organization will have to break down the discussion into several different emails, across different documents and spreadsheets, and several different phone calls. In the risk management solution, every relevant stakeholder can receive notifications from within the system. The discussion with regard to the risk and possible solutions to it can take place from within the system. Upper management can as well pay close attention to the solutions that are being suggested and the progress the organization has made in the system. Instead of each stakeholder contacting one another for updates and information, everyone can have direct access to updates from within the risk management solution.
Monitor and review the risk
It is not every risk that one can eliminate, there are risks that are always present. Examples of these risks include market risks and environmental risks. In the manual risk environment, monitoring takes place through diligent employees. It is critical for these professionals to ensure that they keep a close watch on every risk factor. In a digital risk environment, the system keeps a close watch on the entire risk framework of the organization. A slight change in any of the risk factors immediately becomes visible to everyone. Computers make it easier to continuously monitor risks than human beings. By continually monitoring risks, an organization can ensure continuity. In a digital risk environment, the basics of the risk management process remain unchanged, unlike the manual risk environment.
Methods of risk management
Several approaches exist that investors and managers use in managing risks and uncertainty. These include;
- Operating practices
Risk diversification refers to the method by which an organization reduces unsystematic or specific risks by investing in a number of various assets. The concept behind this is that if one investment undergoes a certain incident that causes it to perform less, other investments will help in balancing it out.
Hedging refers to the process of eliminating the risk or uncertainty by contracting with a counterparty. Examples of such include options, forwards, swaps, and other derivatives that make provision for a degree of certainty with regard to what one can buy and sell an investment for in the future. Investors commonly use hedging to reduce market risk. Business managers as well use this approach to manage costs or lock-in revenues.
A wide range of insurance products exists, that a company can use to protect investors and operators from catastrophic events and losses. Examples are key person insurance, fire insurance, general liability insurance, burglary and theft insurance, property insurance, marine insurance, etc. Although maintaining insurance involves ongoing costs, its payoff is the provision of protection against uncertainties and negative outcomes.
Operating practices are important methods of managing risks. There are varieties of them that managers make use of in order to reduce the amount of risk involved in their businesses. These operating practices include making reviews, analysis, and improvement of safety practices, the use of external consultants to make audits of operational efficiencies, the use of adequate financial planning methods, and the diversification of the business operations.
Another approach that companies can use in lowering the uncertainty of their expected future financial performance is through the reduction of the number of debts they have. Companies that have lower leverage have more flexibility and less risk of bankruptcy or operational seizure.
Other risk management strategies
While dealing with uncertainties, managers employ certain strategies such as;
- Loss Prevention and Reduction
Risk avoidance refers to the act of not taking any action that is risky or is bound to result in uncertainty. Under this approach, one does not participate in activities that could be harmful. Choosing this approach implies that one is completely eliminating the possibility of the occurrences of uncertainties. For example, in an investment, one may do away with any investment if, after every analysis, he finds the investment to become too risky.
It is important for an organization to know that avoiding risk should apply to those risks that will have a major impact. In other words, not every risk should be avoided. This is because some risks come alongside positive opportunities. Therefore, if one avoids such a risk, he is bound to miss those opportunities. Using the example of investment, avoiding the investment may also imply forfeiting its payoffs. For this reason, it is critical to make thorough analyses of risks and carry out informed judgments on such risks. In other words, do not blindly avoid risk as that risk may have several payoffs and positive opportunities. However, there are risks that it is healthy to avoid such as smoking. Knowing fully well that smoking is dangerous /to one’s health, one can mitigate the risk by not participating in the injurious activity as it can lead to ill health and death. So it is healthy to avoid this type of risk.
Retention or acceptance
Retention admits that certain risks are inevitable. Accepting this risk is a cost that helps to offset risks that are larger down the road. This includes selecting health insurance with a lower premium that varies a higher deductible rate. This can refer to the act of accepting a risk without taking any action to mitigate it. This implies that the approach will not reduce the impact of an event. When such a risk is being retained or accepted, it may be that the cost of mitigating the risk exceeds the risk itself. To accept a risk, an organization has to be sure that it will be able to deal with the risk when it comes. Therefore, it is best .to accept a risk only when it has a low tendency of occurring or has a minimal impact when it occurs.
Risk-sharing often takes place usually through employer-based benefits. It makes provision for the company to pay a portion of the insurance premium with the employee to the insurance company. This system in essence shares risks with the company and every employee that partakes in the insurance benefits. This makes us understand that the higher the number of participants sharing the risks, the lower will be the costs of premium. It may be in the best interest of individuals to partake in sharing the risks by choosing employer health care and possibly life insurance plans.
Risk transfer is the act of transferring risk to an external party who bears the risk on behalf of an organization. Transferring the risk does not totally eliminate it. The risk is still in existence but the responsibility with regard to the risk shifts from one organization to another. An example is a bank that enters a deposit insurance policy. In this case, the bank has transferred its risk to an insurance company in exchange for a premium.
The insurance policy stipulates all the terms and conditions that apply, that an individual must meet and maintain for the insurance company to take responsibility for the risk. While accepting risks, the insurance company carefully makes analyses, involving many statistics and algorithms alongside underwriting processes. This is to determine the accurate premium payments equivalent to the requested coverage. When filing claims, the insurer confirms whether the policyholder has met the conditions to provide the contractual payout for the outcome of the risk.
Loss prevention and reduction
The aim of this mechanism is to mitigate risk rather than eliminate it. In other words, loss prevention and reduction attempt to minimize the extent of the loss. While accepting the risk, this mechanism focuses on curtailing the loss and keeping it from spreading. In other words, an organization takes actions to prevent or minimize the impact of the risk. This strategy is common when it comes to risk treatment. We can refer to it as the act of lowering risk. While choosing this approach, an organization will have to work out the measures or actions possible to make the risks more manageable.
For example, the risk of reduction would be present in the manufacturing industry as well as the production of products to incorrect specifications. In this case, making use of quality management schemes will help in lowering the chance of this occurrence. This is a method of risk reduction. This component is to the risk management in the finance industry. Risks here include new regulations. In this case, digital solutions can help in the management of regulatory requirements. These digital schemes can help in the mitigation of lack of compliance. This also is a method of risk reduction.
FAQs on Risk Management
What are the 5 stages of risk management?
The five stages of risk management are risk identification, analysis, evaluation, elimination, and monitoring.
The five stages of risk management are;
- Identify the risk: This is the first step necessary for every organization to take. You cannot manage a risk you have not identified in the first place. Therefore, it is important to know the risk exposure that surrounds an organization’s operating environment. An organization should identify as many risks as possible.
- Analyze the risk: Risk analysis is critical for an organization after identification. This has to do with the scope of the risk and the link that exists between the risk and various factors within the organization. It is important to be able to gauge the severity of the risk. Ask questions with regard to the impact it will have on your organization if it occurs.
- Evaluate and rank the risk: The next stage of risk management is risk evaluation and ranking. solutions to different risks vary on the basis of their severity. In this context, an organization is to rate risks as either high or low. This helps in giving an organization a holistic insight into the risk exposure.
- Treat the risk: Treating the risk has to do with curtailing or eliminating the risk as much as possible. Therefore, it is important to connect with experts in the field under which the risk falls.
- Monitor and review the risk: There are risks that an organization cannot totally eliminate. Such risks are always present and reoccur over time. These risks have to be reviewed periodically and monitored in order to avoid adverse effects.
Chyou is a published author who focuses on the field of international business. After an established career facilitating mergers and acquisitions for medium to large corporations, Chyou turned to writing to help students better understand international business concepts.