Risk management consists of the strategies and tools businesses use to avoid, mitigate, accept or eliminate risks. Innovation and growth always come with some type of risk. Risk management involves identifying and assessing threats to make informed decisions when pursuing innovation and growth. To continue to survive and be profitable, the business must be able to recognise and control risks so they do not adversely affect operations.
Risk management explores the relationship between risks and how one risk materialising could create a domino effect where more risks start to occur. In order for risk management to be effective, it needs to adapt to new and different kinds of risk.
A risk is a future uncertain event that could negatively affect the business. Risk exposure examines how vulnerable a business is to risk. It assesses the future potential impact that a threat might have on the business. Risk exposure is measured by calculating the probability of a risk materialising and the losses that could occur as a result of this.
Risk exposure = Risk impact X Probability
With risk management, companies can calculate their risk exposure and be aware of the effect it will have on their operations. A risk assessment allows an organisation to understand how to respond to a high-risk situation.
Risk exposure can be split into two types: pure risk and speculative risk.
Pure risk cannot be controlled by the business and could either cause losses or nothing at all. By nothing, it means that this category does not provide the organisation with a way to make profit. Examples of pure risk include natural disasters like a fire or theft and property damage. There are no benefits associated with pure risk.
The opposite of pure risk is speculative risk. This category can result either in a gain or a loss. The decisions businesses make have speculative risks. For example, the management might have chosen to invest in an asset. The asset could either bring profits or could incur extra costs for the organisation. Speculative risk is not predictable but it is controlled by the choices the employers make.
Risk appetite and risk tolerance
Risk management examines the risk appetite and tolerance of a business.
Risk appetite looks at how much risk an organisation wants to accept to achieve its objectives. Through identifying and assessing risks, the company can make decisions on whether it is in a position to accept the risks involved with its operations. Risk appetite looks at risk categorisation and the benefits of accepting the risks versus the losses that might occur. Risk appetite involves the use of qualitative data to make better-informed decisions.
These decisions always rely on the industry the entity is operating in, its competitors and the objectives the entity is trying to achieve.
Risk tolerance shows the acceptable level of risk a company can take. People tend to confuse the two terms as they find them quite similar. However, the difference is that risk appetite is the amount of risk a business is willing to accept while risk tolerance indicates the amount of risk a business can accept.
It highlights whether a business will be able to withstand most of the risks resulting in a negative outcome. For example, if a company was small but had a lot of cash in reserves, it could show that it has a high-risk tolerance and can afford to take more risks than a medium size business with no reserves. However, the employer of the small business might have a fairly low-risk appetite and avoid taking many risks.
Risk tolerance looks at the strategies a business uses to mitigate risks and the limits set for how much risk it can handle. It also involves the decisions that might follow after a risk has materialised, or after a business has taken on more risk than it can tolerate.
As seen in the risk management framework, risk management focuses on:
Identifying a risk involves determining what threats the business is facing and finding out the sources of those threats. Managers should comprehensively understand the risks and which areas of the organisation they could impact.
Assessing a risk examines the probability of the risk materialising and the impact it could have on the business. After conducting a risk assessment, management will be able to prioritise risks.
Mitigation offers managers four options: avoidance, reduction, transference or acceptance. Based on the risk assessment the business will need to decide what kind of risk threat they are dealing with and what is the correct approach.
Risk monitoring requires the business to review its current strategies and monitor the risk to track any changes or decide whether different actions need to be taken. The organisation will need to determine if the controls are effective or if new measures will need to be implemented.
The risk management plan
A risk management plan describes the risks the business is facing and how it will approach the risk management process. A company may have multiple risk management plans that address different risks if they are facing many diverse issues. An organisation is always facing the risk of failure, which means they must be prepared to control and manage that risk to protect the organisation.
A risk management plan is different from a risk assessment. It documents the whole process, identification, assessment, mitigation and monitoring, the costs of each risk and strategy and analyses made by management. A risk management plan can outline management decisions based on all the information they have collected.
A risk assessment assists the organisation by identifying and analysing risks. This allows the management to understand the likelihood of a risk and the impact it will have on the business. A risk assessment is not the only tool managers can use; other tools can help in the risk management process. SWOT analysis, risk matrix and risk register can all assist in managing risk. All these tools and their results will then be documented in the risk management plan.
For a risk management plan to be successful the business needs to set clear objectives to be achieved over a specific time frame. Having a schedule will encourage an organised approach to risk management. Businesses need to be clear about when they want each step to be conducted and the costs associated with each risk and step.
It is important that every employee within the risk management team has been assigned a task. This will make it easier for them to communicate and know who is responsible for what. They will know who to contact if there is an emergency and what to do if there is an unplanned event. Well-defined roles can also prevent conflicts from arising during the process.
Risk response strategies
Every organisation will face good and bad risks. Good risks are opportunities for the business to grow. The business is informed of the benefits associated with this type of risk and it is ethical. A bad risk may be the result of the business wanting to take shortcuts. The organisation might make unethical decisions or choose not to comply with rules and regulations to obtain a temporary reward. For example, tax evasion gives the business more money but in the long run it could cause fines and a negative reputation.
After identifying and assessing risks, as part of the mitigation step, the company can address them by:
Avoidance requires the business to develop strategies that would help in preventing the risk from occurring. Risk avoidance can also occur if the business makes the decision not to engage with some type of risk. For example, collaborating with an organisation that has a bad reputation might cause backlash from the community, something that can affect the sales of the business. The company can choose to avoid this risk by not collaborating with the organisation.
Reduction involves making decisions that could either reduce the likelihood of the risk or the impact. Reducing the risk is more complex as the company chooses to take the risk but tries to reduce the consequences that could follow. Management can assess its operations and find where flaws are present, then try to improve them to reduce the likelihood and impact of a risk materialising.
Transference occurs when the business moves the risk to a third party, for example, its insurance. This response is not easy for all types of risks but can be used to mitigate pure risks, such as natural disasters.
Risk acceptance means that the business is willing to accept the risk involved with its decisions as there is no way to avoid or mitigate it. Mitigating the risk may be more expensive than accepting it which is another reason why businesses may choose this response. Deciding whether or not to accept a risk relies heavily on the risk appetite and tolerance of the company.
Risk management is a crucial process for every company. Managers need to focus on creating a risk-aware culture, as well as training employees to recognise potential signs of failure. By understanding the elements of risk management, an entity can create a risk management plan to identify, assess, mitigate and monitor threats. Risk management allows organisations to make better decisions and be prepared in case of an unpredicted event. Not every risk will be under the company’s control, but there are still measures a business can take to prevent potential losses and protect itself from failure.
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