What is Risk Management?

So you have just come out of your Board or Executive committee meeting and you have been asked to help the company establish a risk management programme in your organization. You know what risk management is, broadly, and you have to manage risks in your day-to-day responsibilities. But what does helping your company manage it’s risks across the organization involve? Different parts of the organization may have similar risks, or ones that are completely different to that of your function. How do you bring them together under one place. Maybe they are linked to each other? Maybe there’s an angle or connection that you’re unaware of? What kind of impact will they have if any of them materialize?

These are common questions that risk management, and particularly enterprise risk management (ERM), helps organizations answer these questions. Senior management and the board are interested in having a view of what big, key thematic risks that their company are potentially exposed to, what it’s impact is, and what is being done to make sure that those risks are being addressed in a way to reasonably ensure that they are managed in a way that, if they risk materialized, it won’t derail the company. Another way of looking at it is that they want to make sure that risks are managed with a ‘bandwidth’ so that any ‘shocks’ to the company are within an expected range.

In this article we will take a look at what risk management is from a theory and practice perspective to give you both a high-level understanding of risk, as well as some pointers on what you can do to help your company establish its risk management programme.

Fundamentals of Risk Management

Risk Management can be defined as the process of identifying, assessing, managing, and mitigating both financial, and non-financial threats to an organization’s operations, strategy, and business objectives. When a company sets its strategy and objectives, there are categories of risks that may impede its ability to achieve these goals, such as:

Strategic risk

Operational risk

Financial risk

Regulatory (Compliance) risk

Reputational risk

Third-party (vendor) risk

The goal of risk management is to ensure that the company is on top of these risks and managing them to within an acceptable level so that, should any risks materialize, they are handled in a way that does not cause the firm not to achieve those set goals.

The Cost of Inadequate Risk Management

While some costs of inadequate risk management are immediately apparent, such as financial losses, there may also be longer term implications, such as erosion of stakeholder trust, customer confidence, and overall position in the market that may take a companies years to rebuild. OPEN FAIR divides losses into primary and secondary losses based on how directly stem for a risk event

Primary Losses:

losses that materialize immediately from a risk event

Secondary Losses:

Losses occur as consequence (or ripple) effect of the primary loss event (such as legal or regulatory reprimands, loss of customers/customer confidence, increased insurance premiums)

Generally speaking, primary losses are more immediate and quantifiable and predictable, whilst secondary losses often emerge over a period of time and may be harder to measure, vary significantly based on context and response, and may exceed primary losses in total impact.

It is helpful to think about potential risks in the context of primary and secondary implications as this helps you frame a potential risk in a way that helps your company appreciate the full and wider effect that a materialized risk may have on your company and its operations.

The Five Pillars of Risk Management

1. Identification

Consultation with subject matter experts: One of the most valuable way for your organization it identify potential risks to the organization comes from the experience of individuals in the organization. Their experience, both from within the organization, and from previous roles and experiences, can help senior management identify these potential risks.

Root-cause analysis of previous risk events: History, and learning from it, can sometimes be a way to predict what may happen in the future, if we don’t learn from it. Undertaking root-cause analysis of incidents that the organization has incurred previously is a insightful method for understanding why a risk had previously materialized, and inform ways in which the firm can better prepare for mitigating the effects it has should it occur again.

Review of internal controls through process mapping and analysis: Sometimes getting into the weeds of things is the best way to truly unearth potential risks in an organization. Established and crucial processes in an organization are the bedrock of managing risks. Inherent in processes are controls that, by their nature, are designed to mitigate risks that could occur during the regular undertaking of said process. Understanding and assessing the design and operational effectiveness of these processes and controls can help companies identify potential weaknesses in these processes and ensure that those processes are robust and provide management with reasonable assurance that they are managing their operational risks.

2. Assessment

Effective risk management relies on robust assessment methodologies that combine both qualitative and quantitative approaches, developing a framework for evaluating these risks through multiple lenses. Qualitative assessments relies on using your business’ experts’ judgement and stakeholder inputs to categorize these risks based on their overall severity to the business.

Whilst quantitative approach adds a layer of sophistication and assists in determining any potential financial impacts that they may have. Businesses are increasingly employing advanced statistical techniques such as Monte Carlo simulations to model potential outcomes and their probabilities. These simulations enable organizations to understand the full spectrum of possible scenarios and their financial implications, moving beyond simple point estimates to embrace probability distributions. Historically, banks and financial institutions would solely use Monte Carlo simulation, however non-financial services organizations are increasingly using such methodology to provide greater insights into their overall risk exposure.

Alignment mapping, a crucial yet often overlooked element in risk assessment, systematically examines how risks interconnect and cascade throughout an organization. By understanding these relationships, organizations can better comprehend the systemic nature of risks and how localized events can trigger broader organizational impacts.

3. Mitigation

Once risks are thoroughly assessed, organizations should develop response strategies (also known as risk strategies) that align with their risk appetite and business objectives. Risk treatment options typically span four main approaches: acceptance, avoidance, transfer, and reduce (or mitigate). The key to successful mitigation lies in selecting the right combination of these strategies and allocating limited resources through cost-benefit analysis and considering the organization’s risk capacity.

Building operational resilience is a critical component of risk mitigation. This involves developing robust business continuity plans, establishing redundancies in critical systems and processes, and ensuring the organization is able to maintain essential functions during disruptions. Organizations should look to shifting their focus beyond traditional disaster recovery planning to adopt a more holistic approach to resilience, encompassing people, processes, and technology.

4. Monitoring

Effective risk management requires continuous monitoring through both automated and manual processes. Establishing key risk indicators (KRIs) that serve as early warning signals for emerging risks or deteriorating controls. These metrics should be carefully selected to provide meaningful insights while avoiding information overload. In many cases, these metrics are already being tracked within the organization, however framing the with the lens of risk appetite and tolerance thresholds helps senior management identify and address potential risks to the achievement of its strategy and business objectives

The emergence of artificial intelligence and machine learning has transformed risk monitoring capabilities. These technologies enable real-time analysis of vast amounts of data, identifying patterns and anomalies that might indicate emerging risks. Advanced analytics can predict potential risk events before they materialize, allowing organizations to take preemptive action.

5. Reporting

When developing effective reporting for diverse stakeholders of the organization, whether its the board, executive committee, management, or a regulator, a balance needs to be made to ensure that relevant, actionable insights are provided without information overload. Presenting a risk report with over 300 pages increases the risk of overlooking crucial information, potentially leading decision makers to make uninformed, or less than optimal, choices.

Understanding the requirements of the end-consumer / decision-maker is essential for determining the appropriate depth and breadth of the reporting provided to them. For example, Boards usually prefer high-level overviews of the firm’s enterprise risks, executive committee members look for a hybrid blend of high-level and salient details, where appropriate, whilst more fine-grained detail at management and working level parts of the organization. Engaging these stakeholders prior to developing reporting will guide you in finding the appropriate balance and mix.

Note: regulatory reporting requirements add another layer of complexity, demanding careful attention to compliance standards while maintaining internal utility.

Third Party Vendor Risk Management: Your Extended Enterprise

No organization is an island. No matter what size your company is, you will have suppliers providing your company with goods and services essential to the undertaking of your business. This ecosystem of vendors and partners extends your risk landscape and presents unique risks that extends further than the walls of your organization. The risks faced by your third party vendors are, by extension, your risks too. If your vendor has a cyber security breach, a supply chain disruption, or even goes bankrupt, these risk events will have a knock-on effect to your organization’s ability to serve your customers and continue regular operations. Has your company’s data been stolen? Are you able to produce your products without that key component? Are there alternative suppliers?

While conducting due diligence, risk assessment, onboarding, and regular monitoring of your third-party vendors are essential, it’s equally crucial to understand and map out how these vendors impact your risk and strategic ecosystem. In larger organizations, suppliers may provide services to multiple areas and have separate contracts with each, potentially affecting one area more significantly than another. Understanding the intricate web of your vendors and implementing mitigating actions to ensure the continuity and resilience of your supply chain and operations will help you minimize and prepare for any sudden shocks.

Conclusion

Companies that prioritize risk management gain a strategic advantage by safeguarding their bottom line and strategically expanding their top line through value creation. By effectively identifying, assessing, managing, mitigating, and reporting risks across the organization and your supply chain companies can build operational resilience while pursuing their strategic objectives.

Ready to put risk management to action? Reach out to Risk Llama today to see how we can help!