Risk Management
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Wikipedia-Article "Risk Management"
- For non-business risks, see Risk or the disambiguation page risk analysis.
Generally, Risk Management is the process of measuring, or assessing risk and then developing strategies to manage the risk. In general, the strategies employed include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk. Traditional risk management, which is discussed here, focuses on risks stemming from physical or legal causes (e.g. natural disasters or fires, accidents, death, and lawsuits). Financial risk management, on the other hand, focuses on risks that can be managed using traded financial instruments. Regardless of the type of risk management, all large corporations have risk management teams and small groups and corporations practice informal, if not formal, risk management.
In ideal risk management, a prioritization process is followed whereby the risks with the greatest loss and the greatest probability of occurring are handled first, and risks with lower probability of occurrence and lower loss are handled later. In practice the process can be very difficult, and balancing between risks with a high probability of occurrence but lower loss vs. a risk with high loss but lower probability of occurrence can often be mishandled.
Risk management also faces a difficulty in allocating resources properly. This is the idea of opportunity cost. Resources spent on risk management could be instead spent on more profitable activities. Again, ideal risk management spends the least amount of resources in the process while reducing the negative effects of risks as much as possible.
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Steps in the risk management process
A definitive generic description of risk management that originated in Australia and New Zealand, now being taken up in many other countries, is set out in the Australian & New Zealand STandard 4360:2004. The core of the process is a series of five steps:
- Establish the context - Identify risks - Analyse risks - Evaluate risks - Treat risks
In parallel with the core process, communication & consultation is required to ensure adequate information is provided and conclusions are disemminated. Monitoring and review is an intrinsic part of the process required to ensure that the process is executed in a timely fashion and the identification, analysis, evaluation and treatment are kept up to date.
The standard can be found at www.standards.com.au and simple guidance on its application can be found at www.broadleaf.com.au/tutorials/Default.htm
Establish the context
Establishing the context includes planning the remainder of the process and mapping out the scope of the exercise, the identity and objectives of stakeholders, the basis upon which risks will be evaluated and defining a framework for the process, and agenda for identification and analysis.
Identification
After establishing the context, the next step in the process of managing risk is to identify potential risks. Risks are about events that, when triggered, will cause problems. Hence, risk identification can start with the source of problems, or with the problem itself.
- Source analysis Risk sources may be internal or external to the system that is the target of risk management. Examples of risk sources are: stakeholders of a project, employees of a company or the weather over an airport.
- Problem analysis Risks are related to fear. For example: the fear of losing money, the fear of abuse of privacy information or the fear of accidents and casualties. The fear may exist with various entities, most important with shareholder, customers and legislative bodies such as the government.
When either source or problem is known, the events that a source may trigger or the events that can lead to a problem can be investigated. For example: stakeholders withdrawing during a project may endanger funding of the project; privacy information may be stolen by employees even within a closed network; lightning striking a B747 during takeoff may make all people onboard immediate casualties.
The chosen method of identifying risks may depend on culture, industry practice and compliance. The identification methods are formed by templates or the development of templates for identifying source, problem or event. Common risk identification methods are:
- Objectives-based Risk Identification Organizations and project teams have objectives. Any event that may endanger achieving an objective partly or completely is identified as risk. Objective-based risk identification is at the basis of COSO's Enterprise Risk Management - Integrated Framework
- Scenario-based Risk Identification In scenario analysis different scenarios are created. The scenarios may be the alternative ways to achieve an objective, or an analysis of the interaction of forces in, for example, a market or battle. Any event that triggers an undesired scenario alternative is identified as risk.
- Taxonomy-based Risk Identification The taxonomy in taxonomy-based risk identification is a breakdown of possible risk sources. Based on the taxonomy and knowledge of best practices, a questionnaire is compiled. The answers to the questions reveal risks. Taxonomy-based risk identification in software industry can be found in CMU/SEI-93-TR-6.
- Common-risk Checking In several industries lists with known risks are available. Each risk in the list can be checked for application to a particular situation. An example of known risks in the software industry is the Common Vulnerability and Exposures list found at http://cve.mitre.org.
Assessment
Once risks have been identified, they must then be assessed as to their potential severity of loss and to the probability of occurrence. These quantities can be either simple to measure, in the case of the value of a lost building, or impossible to know for sure in the case of the probability of an unlikely event occurring. Therefore, in the assessment process it is critical to make the best educated guesses possible in order to properly prioritize the implementation of the risk management plan.
The fundamental difficulty in risk assessment is determining the rate of occurrence since statistical information is not available on all kinds of past incidents. Furthermore, evaluating the severity of the consequences (impact) is often quite difficult for immaterial assets. Asset valuation is another question that needs to be addressed. Thus, best educated opinions and available statistics are the primary sources of information. Nevertheless, risk assessment should produce such information for the management of the organisation that the primary risks are easy to understand and that the risk management decisions may be prioritized. Thus, there have been several theories and attempts to quantify risks. Numerous different risk formulae exist, but perhaps the most widely accepted formula for risk quantification is: Rate of occurrence multiplied by the impact of the event equals risk
Later research has shown that the financial benefits of risk management are not so much dependent on the formulae used. The most significant factor in risk management seems to be that 1.) risk assessment is performed frequently and 2.) it is done using as simple methods as possible.
In business it is imperative to be able to present the findings of risk assessments in financial terms. Robert Courtney Jr. (IBM, 1970) proposed a formulae for presenting risks in financial terms. The Courtney formulae was accepted as the official risk analysis method for the US governmental agencies. The formulae proposes calculation of ALE (Annualised 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: (Dorfman, 1997)
- Transfer
- Avoidance
- Reduction (aka Mitigation)
- Acceptance (aka Retention)
Ideal use of these 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.
Risk avoidance
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 liability that comes with it. Another would be not flying in order to not 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 the profits.
Risk reduction
Involves methods that reduce the severity of the loss. Examples include sprinklers 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.
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 increments, software projects can limit effort wasted to a single increment. A current trend in software development, spearheaded by the Extreme Programming community, is to reduce the size of increments to the smallest size possible, sometimes as little as one week is allocated to an increment.
Risk retention
Involves accepting the loss 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 transfer
Means causing another party to accept the risk, typically by contract or by hedging. Insurance is one type of risk transfer that uses contracts. Other times it may involve contract language that transfers a risk to another party without the payment of an insurance premium. Liability among construction or other contractors is very often transferred this way. On the other hand, taking offsetting positions in derivatives is typically how firms use hedging to financially manage risk.
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.
Create the plan
Decide on the combination of methods to be used for each risk
Implementation
Follow 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.
Limitations
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.
Prioritizing too highly the Risk management processes itself could potentially 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.
Areas of risk management
As applied to corporate finance, risk management is a technique for measuring, monitoring and controlling the financial or operational risk on a firm's balance sheet. See value at risk.
Enterprise Risk Management
In Enterprise Risk Management, a risk is defined as a possible event or circumstance that can have negative influences on the Enterprise in question. Its impact can be on the very existance, the resources (human and capital), the products and services, or the customers of the Enterprise, as well as external impacts on Society, Markets or the Environment. ((Author's Note Amazingly whenever Risk is considered this is often the last Risk to be formally evaluated with such things as Project Risk receiving much higher attention??))
Project management
In project management, a risk is more narrowly defined as a possible event or circumstance that can have negative influences on a project. Its influence can be on the schedule, the resources, the scope and/or the quality.
In project management parlance, when a risk escalates, it becomes a liability. A liability is a negative event or circumstance that is hindering the project.
Some of the processes for assessing risk include the following (the parentheses contain some of the jargon used to refer to them).
- Choosing unique identifiers for referring to the same risk in company or project documents (identification).
- Describing the risk and how it could become a liability (description).
- Assessing the consequences of that (effect).
- Considering what precautions could be taken to prevent it (precaution).
- Drawing up contingency plans or procedures for handling it (contingency).
- Categorizing the risk as new, ongoing or closed (risk status)
- Estimating the probability of the risk becoming a liability (Risk escalation probability, P)
- Estimating the consequences in terms of time for the project (Schedule impact, S)
In addition, every probable risk can have a pre-formulated plan to deal with it to deal with its possible consequences (to ensure contingency if the risk becomes a liability).
From the information above and the average cost per employee over time, or Cost Accrual Ratio, a project manager can estimate
- the cost associated with the risk if it arises, estimated by multiplying employee costs per unit time by the estimated time lost (cost impact, C where C = Cost Accrual Ratio * S)
- the probable increase in time associated with a risk (schedule variance due to risk, Rs where Rs = P * S):
- Sorting on this value puts the highest risks to the schedule first. This is intended to cause the greatest risks to the project to be attempted first so that risk is minimized as quickly as possible.
- This is slightly misleading as schedule variances with a large P and small S and visa-versa are not equivalent. (The risk of the RMS Titanic sinking vs. the passengers' meals being served at slightly the wrong time).
- the probable increase in cost associated with a risk (cost variance due to risk, Rc where Rc = P*C = P*CAR*S = P*S*CAR)
- sorting on this value puts the highest risks to the budget first.
- see concerns about schedule variance as this is a function of it, as illustrated in the equation above.
Risk in a project or process can be due either to special causes of deviation or common causes of deviation and requires appropriate treatment. That is to re-iterate the concern about extremal cases not being equivalent in the list immediately above.
Risk management activities as applied to project management
In project management, risk management includes the following activities:
- Planning how risk management will be held in the particular project. Plan should include risk management tasks, responsibilities, activities and budget.
- Assigning risk officer - a team member other than a project manager who is responsible for foreseeing potential project problems. Typical characteristic of risk officer is a healthy skepticism.
- Maintaining live project risk database. Each risk should have the following attributes: opening date, title, short description, probability and importance. Optionally risk can have assigned person responsible for its resolution and date till then risk still can be resolved.
- Creating anonymous risk reporting channel. Each team member should have possibility to report risk that he foresees in the project.
- Preparing mitigation plans for risks that are chosen to be mitigated. The purpose of the mitigation plan is to describe how this particular risk will be handled – what, when, by who and how will be done to avoid it or minimize consequences if it becomes a liability.
- Summarizing planned and faced risks, effectiveness of mitigation activities and effort spend for the risk management.
References
- Dorfman, Mark S. (1997). Introduction to Risk Management and Insurance (6th ed.), Prentice Hall. ISBN 0137521065.
- Stulz, René M. (2003). Risk Management & Derivatives (1st ed.), Mason, Ohio: Thomson South-Western. ISBN 0-538-86101-0.
- Alijoyo, Antonius (2004). Focused Enterprise Risk Management (1st ed.), PT Ray Indonesia, Jakarta. ISBN 979-9891818-1-7.
Further reading
- Alexander, Carol and Sheedy, Elizabeth (2004). The Professional Risk Managers' Handbook: A Comprehensive Guide to Current Theory and Best Practices (1st ed.), Wilmington, DE: PRMIA Publications. ISBN 0-9766097-0-3.Learn More
- information risk premium (article)
See also
- Risk
- Financial risk management
- Critical chain
- Earned value management
- Insurance
- Precautionary principle
- Project management
- Substantial equivalence
- Value at risk
- List of finance topics
- List of project management topics
- Chief Risk Officer
- Risk homeostasis
External links
Risk Management Certification programs
- The Professional Risk Manager Certification (PRM)
- IIA & CPCU Associate in Risk Management Certification (ARM)
- RMA Certification
- GARP Certification
- BAI Certified Risk Professional
- IIA Certification in Control Self-Assessment