Risk management includes the identification, analysis, and response to risk factors that form part of the life of a business. Effective risk management means attempting to control future outcomes by acting proactively rather than reactively. So, effective risk management offers the potential to reduce both the possibility of a risk occurring and its potential impact.
The goal of risk management is to ensure that the company takes action in time to prevent an emergency or minimize losses. Meanwhile, risk management helps companies understand which risks are worth taking for helping ensure their success. To be precise, if you see bumps in the road ahead, you have some time to decide whether to slow down or drive around them.
What is risk management and why is it important?
Risk management is about identifying, assessing and controlling risks to the business. This involves policies, procedures and controls that are designed to transfer the potentially adverse effects of risk events from the organization to its risk-bearing functions (such as insurance or financial markets). It is about reducing the probability that an adverse event will happen and, where it does occur, reducing its impact.
The most effective risk management is done on a proactive basis rather than a reactive one. The methods used are often proactive in nature (for example, hedging is about gaining exposure to a market in advance of need). And this is not just because it minimizes uncertainty but also because it gives the business some control over its risks and makes them easier to understand and manage.
Risk management is important for a business to have because it’s about managing the business. Effective risk management has the potential to reduce both the possibility of an adverse event happening and its impact if it does occur. The more effective the risk management systems and controls are, the more likely it is an adverse event will not happen; or that if it does occur it will be minimized in terms of its impact. So, effective risk management will usually result in a better financial performance for the business.
How does risk management system work in business?
Risk management techniques, such as hedging, are often just part of the overall risk management system. For example, a mine owner might want to use insurance to cover for potential risks and the costs associated with loss of profits or revenue arising from a disastrous accident. The insurance policy will include clauses that restrict the level of compensation for damage claim to prevent over compensation in the event of an accident.
But it also includes provisions for agreeing on how much will be paid out in this event and how this will be capped at some point in time – effectively meaning that a mine owner can only really lose a certain amount if an accident did occur. The mine owner is then able to determine how much it is willing to pay to insure against this loss.
In this way, the insurance can act as a type of risk transfer mechanism. It allows both the insurance company and the mine owner to manage their risks better. (The same approach is used in other industries where insuring against risks is often seen as a high priority.)
Risk management in business today has become very complex and involves many aspects including analysis of qualitative and quantitative risk factors, evaluation of risk tolerance for specific threat levels, cost-benefit analysis for intervention strategies, etc. Because of such complexity, computer software is often used for information gathering and analysis purposes.
What is meant by analysis of qualitative and quantitative risk factors?
This is an important part of the risk management process. As mentioned earlier, analysis of qualitative and quantitative risk factors involves identifying and understanding the risk factors that form part of the business. There are four main types of risk factor:
Quantitative factors: These are variables that can be measured (such as a sales target or profit margin), as well as changeable variables such as interest rates or exchange rates. When they are changed they will have a direct impact on the business, though often being difficult to predict;
Qualitative factors: These are things such as human skills, attitudes and emotions. These can be difficult to measure and manage (particularly in a business context). For example, they could include the skills of particular employees or the amount of goodwill a particular brand possesses;
Unknowns: These are risk factors that cannot be quantified and may only be identified when an adverse event has already occurred (that is, they are not known until they become known);
Unknown unknowns: These are factors that haven’t yet been identified as risks. It’s impossible to completely identify all possible risks up front. But, as a business grows and changes, new risks may emerge; and therefore it’s important to ensure that risk identification is not seen as complete.
How is the evaluation of risk tolerance for specific threat levels done?
For this, different vulnerability categories are used. Each of these categories is associated with a specific level of risk. Risk tolerance is the estimate of what level of likelihood a business will be prepared to accept for each threat category. This is a practical and subjective measure. The assumption here is that once the risk tolerance has been established, the management team will be able to make decisions about how to respond in the future; and how to maintain or improve their financial performance as a result; in this way it acts as a decision-making tool. For the evaluation of risk tolerance for specific threat levels, there are four main categories of risk tolerance:
Awareness: the future threat is known and measures can be taken to avoid the adverse event;
Impact level: The adverse event has significant impact on the business (either in terms of financial performance or reputation);
Recovery options: The threat has an impact on the business, but it can recover from this. This includes threats such as business disruption, loss of revenue and reputation; and
Effect levels: The impact may have a minor effect on the business. These threats include theft, privacy violation, system failure or loss of data.
Formal risk management systems use clear definitions for these categories to guide decision makers using them for managing different types of risk in the future.
What about cost-benefit analysis for intervention strategies?
The cost-benefit analysis for intervention strategies involves an analysis of the costs of taking action (such as buying insurance) and the benefits of taking action. This is done to determine whether the business should take actions such as:
The cost-benefit analysis for intervention strategies is usually required when there are uncertainties surrounding a risk event; the risk event that has a higher level of potential impact. For example, if there is uncertainty about the health effects from environmental pollution, this might make it difficult to calculate how much of an impact this will have on human health. But one thing is for sure – in instances like this: Financial performance matters and there needs to be maximum control over any aspects that may have a significant impact on future financial performance.
In short, risk is important for a business to have because:
- risk shows the uncertainty of the future (the best guess of what will happen is always wrong)
- risk brings out new opportunities for a business
- and, risk management protects a business from its customers and competitors.
What are the differences between the business continuity management and the risk management?
The business continuity management is the process of planning, preparing, and responding to the impact of an emergency or disaster affecting one or more parts of the business. The relationship between business continuity and risk management generally depends on the organization. In most cases, business continuity is as a sub-domain of risk management. This could include natural hazards such as floods, earthquakes or civil emergencies such as terrorist attacks. The purpose of this is to ensure that any potential disruption to operations is minimised. This often involves a mix of information systems and procedures, including:
Changing a risk management plan to reflect these new circumstances would be difficult. A business continuity management plan would need updating immediately to be able to respond effectively to any changes in circumstances.
Risk management on the other hand requires a flexible approach that can adapt if necessary and evolve over time. So it can deal with new types of risk and new circumstances that arise in the future. The risk management process involves considering what is important to the business, identifying risk and then implementing suitable strategies to control or manage it.
The business continuity management plan is a subset of a larger risk management plan. And it will be affected by the overall risk profile of a business. This is because the purpose of a business continuity management plan is to create processes. The process will minimize disruption to normal operations in the event that an emergency or disaster does take place.
So, risk management is important for a business to have. It’s because it helps a business stay competitive in the competitive worldwide market. It helps a business gain from the uncertainty of their future and helps them get ahead of their competition. Risk management is all about preventing or dealing with risks and uncertainty in a proactive way before being too late; or before it becomes too costly to deal with.
Business Continuity Management is the process by which an organization plans for, and responds to, an emergency situation, so as to keep critical business operations continuous while minimizing the effect on the organization.