Risk management

What is Risk Management?

Risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions. Essentially, risk management occurs any time an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given his investment objectives and risk tolerance.

Risk management is a systematic process of identifying and assessing company risks and taking actions to protect a company against them. The task of the risk manager is to predict and enact measures to control or prevent losses within a company. The risk-management process involves identifying exposures to potential losses, measuring these exposures, and deciding how to protect the company from harm given the nature of the risks and the company’s goals and resources. Some risk managers define risk as the possibility that a future occurrence may cause harm or losses, while noting that risk also may provide possible opportunities. By taking risks, companies sometimes can achieve considerable gains. However, companies need risk management to analyze possible risks in order to balance potential gains against potential losses and avoid expensive mistakes.

Risks can come from various sources including uncertainty in financial markets, threats from project failures (at any phase in design, development, production, or sustainment life-cycles), legal liabilities, credit risk, accidents, natural causes and disasters, deliberate attack from an adversary, or events of uncertain or unpredictable root-cause. There are two types of events i.e. negative events can be classified as risks while positive events are classified as opportunities. Several risk management standards have been developed including the Project Management Institute, the National Institute of Standards and Technology, actuarial societies, and ISO standards. Methods, definitions and goals vary widely according to whether the risk management method is in the context of project management, security, engineering, industrial processes, financial portfolios, actuarial assessments, or public health and safety.

Strategies to manage threats (uncertainties with negative consequences) typically include avoiding the threat, reducing the negative effect or probability of the threat, transferring all or part of the threat to another party, and even retaining some or all of the potential or actual consequences of a particular threat, and the opposites for opportunities (uncertain future states with benefits).

Risk Management Standards

A number of standards have been developed worldwide to help organisations implement risk management systematically and effectively. These standards seek to establish a common view on frameworks, processes and practice, and are generally set by recognised international standards bodies or by industry groups. Risk management is a fast-moving discipline and standards are regularly supplemented and updated.

The different standards reflect the different motivations and technical focus of their developers, and are appropriate for different organisations and situations. Standards are normally voluntary, although adherence to a standard may be required by regulators or by contract.

IRM professional qualifications seek to equip students with the knowledge and judgement to select the appropriate standard or standards for use within their organisation.

Commonly used standards include:

  • ISO 31000 2009 – Risk Management Principles and Guidelines.
  • A Risk Management Standard – IRM/Alarm/AIRMIC 2002 – developed in 2002 by the UK’s 3 main risk organisations.
  • ISO/IEC 31010:2009 – Risk Management – Risk Assessment Techniques.
  • COSO 2004 – Enterprise Risk Management – Integrated Framework.
  • OCEG “Red Book” 2.0: 2009 – a Governance, Risk and Compliance Capability Model.

Method

For the most part, these methods consist of the following elements, performed, more or less, in the following order.

  1. identify, characterize threats;
  2. assess the vulnerability of critical assets to specific threats;
  3. determine the risk (i.e. the expected likelihood and consequences of specifictypes of attacks on specific assets);
  4. identify ways to reduce those risks;
  5. prioritize risk reduction measures based on a strategy.

Principles of risk management

The International Organization for Standardization (ISO) identifies the following principles of risk management:

Risk management should:

  • create value – resources expended to mitigate risk should be less than the
  • consequence of inaction;
  • be an integral part of organizational processes;
  • be part of decision making process;
  • explicitly address uncertainty and assumptions;
  • be a systematic and structured process;
  • be based on the best available information;
  • be tailorable;
  • take human factors into account;
  • be transparent and inclusive;
  • be dynamic, iterative and responsive to change;
  • be capable of continual improvement and enhancement;
  • be continually or periodically re-assessed.

Types Of Risk

Risk managers need to be aware of the types of risks they face. Common types of risks include automobile accidents, employee injuries, fire, flood, and tornadoes, although more complicated types such as liability and environmental degradation also exist. Furthermore, companies face a number of risks that stem primarily from the nature of doing business. In Beyond Value at Risk (1998) Kevin Dowd sums up these different types of risks companies face by placing them in five general categories:

  1. Business risks or those associated with an organization’s particular market or industry.
  2. Market risks or those associated with changes in market conditions, such as fluctuations in prices, interest rates, and exchange rates.
  3. Credit risks or those associated with the potential for not receiving payments owed by debtors.
  4. Operational risks or those associated with internal system failures because of mechanical problems (e.g., machines malfunctioning) or human errors (e.g., poor allocation of resources).
  5. Legal risks or those associated with the possibility of other parties not meeting their contractual obligations.

Environmental risks constitute a significant and growing area of risk management, since reports indicate the number and intensity of natural disasters are increasing. For example, the periodical Risk Management reported that there were about five times as many natural disasters in the 1990s as in the 1960s, and the 2000s seemed to continue this trend. In 2004, three major hurricanes hit the state of Florida, and a tsunami caused death and incalculable devastation in the Pacific Rim. Hurricane Katrina, which hit the Gulf Coast in 2005, was the costliest hurricane in U.S. history. Analysts expect that the twenty-first century will be just as bad as or worse than the past. Some observers blame the rising number of natural disasters on global warming, which they believe will cause greater floods, droughts, and storms in the future. Whatever the cause, it is clear that natural disasters are wreaking expensive havoc.

Any given risk can lead to a variety of losses in different areas. For example, if a fire occurs, a company could lose its physical property such as buildings, equipment, and materials. In this situation, a company also could lose

Revenues, in that it could no longer produce goods or provide services. Furthermore, a company could lose human resources in such a disaster. Even if employees are not killed or injured, a company would still suffer losses because employers must cover benefits employees draw when they miss work.

Risk options

Risk mitigation measures are usually formulated according to one or more of the following major risk options, which are:

  1. Design a new business process with adequate built-in risk control and containment measures from the start.
  2. Periodically re-assess risks that are accepted in ongoing processes as a normal feature of business operations and modify mitigation measures.
  3. Transfer risks to an external agency (e.g. an insurance company).
  4. Avoid risks altogether (e.g. by closing down a particular high-risk business area).

Later research has shown that the financial benefits of risk management are less dependent on the formula used but are more dependent on the frequency and how risk assessment is performed.

In business it is imperative to be able to present the findings of risk assessments in financial, market, or schedule terms. Robert Courtney Jr. (IBM, 1970) proposed a formula for presenting risks in financial terms. The Courtney formula was accepted as the official risk analysis method for the US governmental agencies. The formula proposes calculation of ALE (annualized loss expectancy) and compares the expected loss value to the security control implementation costs (cost-benefit analysis).

Potential risk treatments

Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four major categories:

  1. Avoidance (eliminate, withdraw from or not become involved).
  2. Reduction (optimize – mitigate).
  3. Sharing (transfer – outsource or insure).
  4. Retention (accept and budget).

Ideal use of these risk control strategies may not be possible. Some of them may involve trade-offs that are not acceptable to the organization or person making the risk management decisions. Another source, from the US Department of Defense (see link), Defense Acquisition University, calls these categories ACAT, for Avoid, Control, Accept, or Transfer. This use of the ACAT acronym is reminiscent of another ACAT (for Acquisition Category) used in US Defense industry procurements, in which Risk Management figures prominently in decision making and planning.

Risk avoidance

This includes not performing an activity that could carry risk. An example would be not buying a property or business in order to not take on the legal liability that comes with it. Another would be not flying in order not to take the risk that the airplane were to be hijacked. Avoidance may seem the answer to all risks, but avoiding risks also means losing out on the potential gain that accepting (retaining) the risk may have allowed. Not entering a business to avoid the risk of loss also avoids the possibility of earning profits. Increasing risk regulation in hospitals has led to avoidance of treating higher risk conditions, in favor of patients presenting with lower risk.

Risk reduction

Risk reduction or “optimization” involves reducing the severity of the loss or the likelihood of the loss from occurring. For example, sprinklers are designed to put out a fire to reduce the risk of loss by fire. This method may cause a greater loss by water damage and therefore may not be suitable. Halon fire suppression systems may mitigate that risk, but the cost may be prohibitive as a strategy.

Acknowledging that risks can be positive or negative, optimizing risks means finding a balance between negative risk and the benefit of the operation or activity; and between risk reduction and effort applied. By an offshore drilling contractor effectively applying HSE Management in its organization, it can optimize risk to achieve levels of residual risk that are tolerable.

Modern software development methodologies reduce risk by developing and delivering software incrementally. Early methodologies suffered from the fact that they only delivered software in the final phase of development; any problems encountered in earlier phases meant costly rework and often jeopardized the whole project. By developing in iterations, software projects can limit effort wasted to a single iteration.

Outsourcing could be an example of risk reduction if the outsourcer can demonstrate higher capability at managing or reducing risks. For example, a company may outsource only its software development, the manufacturing of hard goods, or customer support needs to another company, while handling the business management itself. This way, the company can concentrate more on business development without having to worry as much about the manufacturing process, managing the development team, or finding a physical location for a call center.

Risk sharing

Briefly defined as “sharing with another party the burden of loss or the benefit of gain, from a risk, and the measures to reduce a risk.”

The term of ‘risk transfer’ is often used in place of risk sharing in the mistaken belief that you can transfer a risk to a third party through insurance or outsourcing. In practice if the insurance company or contractor go bankrupt or end up in court, the original risk is likely to still revert to the first party. As such in the terminology of practitioners and scholars alike, the purchase of an insurance contract is often described as a “transfer of risk.” However, technically speaking, the buyer of the contract generally retains legal responsibility for the losses “transferred”, meaning that insurance may be described more accurately as a post-event compensatory mechanism. For example, a personal injuries insurance policy does not transfer the risk of a car accident to the insurance company. The risk still lies with the policy holder namely the person who has been in the accident. The insurance policy simply provides that if an accident (the event) occurs involving the policy holder then some compensation may be payable to the policy holder that is commensurate with the suffering/damage.

Some ways of managing risk fall into multiple categories. Risk retention pools are technically retaining the risk for the group, but spreading it over the whole group involves transfer among individual members of the group. This is different from traditional insurance, in that no premium is exchanged between members of the group up front, but instead losses are assessed to all members of the group.

Risk retention

Involves accepting the loss, or benefit of gain, from a risk when it occurs. True self insurance falls in this category. Risk retention is a viable strategy for small risks where the cost of insuring against the risk would be greater over time than the total losses sustained. All risks that are not avoided or transferred are retained by default. This includes risks that are so large or catastrophic that they either cannot be insured against or the premiums would be infeasible. War is an example since most property and risks are not insured against war, so the loss attributed by war is retained by the insured. Also any amounts of potential loss (risk) over the amount insured is retained risk. This may also be acceptable if the chance of a very large loss is small or if the cost to insure for greater coverage amounts is so great it would hinder the goals of the organization too much. Risk retention or acceptance is common type of risk response on treats and opportunities.

Risk Management plan

Select appropriate controls or countermeasures to measure each risk. Risk mitigation needs to be approved by the appropriate level of management. For instance, a risk concerning the image of the organization should have top management decision behind it whereas IT management would have the authority to decide on computer virus risks.

The risk management plan should propose applicable and effective security controls for managing the risks. For example, an observed high risk of computer viruses could be mitigated by acquiring and implementing antivirus software. A good risk management plan should contain a schedule for control implementation and responsible persons for those actions.

According to ISO/IEC 27001, the stage immediately after completion of the risk assessment phase consists of preparing a Risk Treatment Plan, which should document the decisions about how each of the identified risks should be handled. Mitigation of risks often means selection of security controls, which should be documented in a Statement of Applicability, which identifies which particular control objectives and controls from the standard have been selected, and why.

Implementation

Implementation follows all of the planned methods for mitigating the effect of the risks. Purchase insurance policies for the risks that have been decided to be transferred to an insurer, avoid all risks that can be avoided without sacrificing the entity’s goals, reduce others, and retain the rest.

Review and evaluation of the plan

Initial risk management plans will never be perfect. Practice, experience, and actual loss results will necessitate changes in the plan and contribute information to allow possible different decisions to be made in dealing with the risks being faced.

Risk analysis results and management plans should be updated periodically. There are two primary reasons for this:

  1. to evaluate whether the previously selected security controls are still applicable and effective
  2. to evaluate the possible risk level changes in the business environment. For example, information risks are a good example of rapidly changing business environment.

Limitations

Prioritizing the risk management processes too highly could keep an organization from ever completing a project or even getting started. This is especially true if other work is suspended until the risk management process is considered complete.

It is also important to keep in mind the distinction between risk and uncertainty. Risk can be measured by impacts x probability.

If risks are improperly assessed and prioritized, time can be wasted in dealing with risk of losses that are not likely to occur. Spending too much time assessing and managing unlikely risks can divert resources that could be used more profitably. Unlikely events do occur but if the risk is unlikely enough to occur it may be better to simply retain the risk and deal with the result if the loss does in fact occur. Qualitative risk assessment is subjective and lacks consistency. The primary justification for a formal risk assessment process is legal and bureaucratic.

Areas

As applied to corporate finance, risk management is the technique for measuring, monitoring and controlling the financial or operational risk on a firm’s balance sheet, a traditional measure is the value at risk (VaR), but there also other measures like profit at risk (PaR) or margin at risk. The Basel II framework breaks risks into market risk (price risk), credit risk and operational risk and also specifies methods for calculating capital requirements for each of these components.

In Information Technology, Risk management includes “Incident Handling”, an action plan for dealing with intrusions, cyber-theft, denial of service, fire, floods, and other security-related events. According to the SANS organization, it is a six step process: Preparation, Identification, Containment, Eradication, Recovery, and Lessons Learned.

 

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