August 26, 2022 | 6-minute read (1076 words)
Risk management is defined as the process of identifying, analyzing and controlling threats to your business’s financial security.
As any business owner can attest, multiple sources pose risks, such as legal liabilities, financial uncertainties, errors in strategic management, natural disasters and accidents. Their impact may range from minor to potentially disastrous.
One of your primary objectives in running a business is to control these risks by identifying those that are most likely to occur, as well as devising tactics to avoid or prepare for them.
A well-conceived risk-management program formalizes this process. It pushes businesses to assess the complete scope of risks they face and the impact they could exert on its strategic goals. Risk management also entails producing strategies to address these risks, based on their likelihood of transpiring and their potential degree of impact.
Behind risk management’s rise to the fore
The risk landscape for businesses today has become increasingly complex. Globalization and the widespread adoption of digital technologies have precipitated the emergence of new risks with which businesses must contend. Meanwhile, the coronavirus has also forced businesses to grapple with matters such as employee safety, how to interact with customers and massively disrupted supply chains.
Businesses may have adjusted their operations in response, but they are still struggling with risks such as whether to open offices completely and how to make their supply chains more resilient. The cumulative effect of grappling with this onslaught of risks is prompting a reevaluation of risk management plans to prioritize a proactive approach as opposed to a reactive one.
When businesses can identify a risk at their incipient stage, managing that risk is much more straightforward than being caught off-guard and forced to react once it’s reached the level of a crisis. Early risk identification, in turn, boosts prudent decision-making and strategic business management.
This translates to an organization’s success being predicated, at least in part, on its risk-management strategy.
The cost of risk metric
Cost of risk, sometimes referred to as COR, is a risk-management tool that measures the total cost, both direct and indirect, to manage risk exposure. This key metric tracks actual spending on risk-management activities against projected spending and helps businesses gauge how well risk is being managed.
In other words, the cost of risk represents the collective expenses of a business related to any risk, such as control costs, transfer costs, retained losses (uninsured), costs of risk mitigation, loss adjustment costs and the cost of running a risk management program. Cost of risk is determined every fiscal period, and every element of the cost of risk is viewed as an investment and should demonstrate ROI.
To control risk exposure, most organizations allot a percentage of their annual budget to risk management activities. Those in charge are tasked with identifying business risks and devising strategies for controlling risk exposure before a loss is incurred. If the cost of managing risk is less than the profits realized by the organization during a given period, the risk management budget allocation is seen favorably.
Types of risk
Perform a strengths, weakness, opportunities and threats analysis to identify risks linked to your business. The process involves examining internal strengths and weaknesses that you can control, as well as external forces that are beyond your control. Your focus will be on the internal weaknesses and external risks that are most likely to have a negative impact on your business.
Your ability to meet your business objectives may be hampered by internal weaknesses, which represent a type of risk. These could include factors like labor shortages, outdated equipment or software, poor morale and financial limitations, to name a few.
Employee-related risks that jeopardize business growth, such as illness, low productivity and fraud, are referred to as human risk.
Another type of internal risk is technological risk, relating for example to hardware, software, equipment malfunction or an insufficient investment in IT.
The third type of internal risk is called physical risk, which refers to loss of or damage to a business’s assets, such as buildings, equipment and employees.
It is of the utmost importance to be mindful of external risks as they relate to your industry or trade. External risks can typically be classified as competition risks, environmental risks and economic risks.
Competition risks can come in different forms, such as price point differences with competitors, the higher popularity of competing products, the preferable location of a competitor or a competitor whose more favorable amenities keep attrition low.
Environmental risks may comprise natural disasters, changes in local laws, a shift in the community or leasing issues.
Economic risks are factors such as recession, a tight job market and interest rate hikes.
Risk management process
Conducting a risk assessment will help you identify and rank the risks that are most likely to have an impact on your organization. To conduct a risk assessment:
1. Identify: Make a list of potential worst-case scenarios.
2. Record and monitor: Decide how you will monitor each risk you have identified and record accordingly.
3. Develop a response plan: Decide how you will lower the probability of each risk occurring, including what measures will be taken. Start with the scenarios that are the most apt to happen and that could cause the greatest harm.
4. Review: Revisit your risk-assessment program either every year, or whenever changes to your business operations or external environment warrant a new plan.
Risk response strategies
There are five generally accepted methods for responding to risk, as outlined below.
1. Risk avoidance: This refers to avoiding actions that could have a negative impact on your business to minimize risk.
2. Risk reduction: This refers to working to reduce the impact of a risk rather than trying to prevent risk altogether.
3. Risk sharing: This refers to sharing risks, so that the potential of any loss shifts to the entire group rather than one party.
4. Risk transfer: This refers to the contractual transfer of risk to a third party, such as insurance, shifting the risk from proprietor to insurance provider.
5. Risk acceptance: This refers to the idea that eradicating every risk is not possible; what is left behind is known as “residual risk.”
Risks can hinder your business’s survival and growth. Your risk-management plan should focus on anticipating and prioritizing risks across the organization. The goal is not to eliminate every risk; instead, it is to help improve risk decision-making.