Risk is a concept that denotes
a potential negative impact to an asset or some characteristic of value that may
arise from some present process or future event. In everyday usage, risk is
often used synonymously with the probability of a known loss. Paradoxically, a
probable loss can be uncertain and relative in an individual event while having
a certainty in the aggregate of multiple events.
Risk is the possibility of an event occurring that will have an impact on the
achievement of objectives.
Risk is measured in terms of impact and likelihood. Risk communication and risk
perception are essential factors for all human decision making.
Definitions Of Risk
There are many more and less precise definitions of risk; they depend on
specific applications and situational contexts.
Financial risk. is often defined as the unexpected variability or volatility of
returns and thus includes both potential worse-than-expected as well as
better-than-expected returns.
In statistics, risk is often mapped to the probability of some event which is
seen as undesirable. Usually, the probability of that event and some assessment
of its expected harm must be combined into a believable scenario (an outcome),
which combines the set of risk, regret and reward probabilities into an expected
value for that outcome.
In information security, a risk is defined as a function of three variables:
1. the probability that there is a threat
2. the probability that there are any vulnerabilities
3. the potential impact.
If any of these variables approaches zero, the overall risk approaches zero.
The management of actuarial risk is called risk management.
Risk Management
Risk management is the human activity which integrates recognition of risk, risk
assessment, developing strategies to manage it, and mitigation of risk using
managerial resources.
The strategies 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.
Some traditional risk managements are focused 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.
Objective of risk management is to reduce different risks related to a
preselected domain to the level accepted by society. It may refer to numerous
types of threats caused by environment, technology, humans, organizations and
politics. On the other hand it involves all means available for humans, or in
particular, for a risk management entity (person, staff, organization).
Some Explanations
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
in descending order. In practice the process can be very difficult, and
balancing between risks with a high probability of occurrence but lower loss
versus a risk with high loss but lower probability of occurrence can often be
mishandled.
Intangible risk management identifies a new type of risk - a risk that has a
100% probability of occurring but is ignored by the organization due to a lack
of identification ability. For example, when deficient knowledge is applied to a
situation, a knowledge risk materialises. Relationship risk appears when
ineffective collaboration occurs. Process-engagement risk may be an issue when
ineffective operational procedures are applied. These risks directly reduce the
productivity of knowledge workers, decrease cost effectiveness, profitability,
service, quality, reputation, brand value, and earnings quality. Intangible risk
management allows risk management to create immediate value from the
identification and reduction of risks that reduce productivity.
Risk management also faces difficulties allocating resources. This is the idea
of opportunity cost. Resources spent on risk management could have been spent on
more profitable activities. Again, ideal risk management minimizes spending
while maximizing the reduction of the negative effects of risks.
Steps in the risk management process
Establish the context
Establishing the context involves
0. Identification of risk in a selected domain of interest
1. Planning the remainder of the process.
2. Mapping out the following: the social scope of risk management, the identity
and objectives of stakeholders, and the basis upon which risks will be
evaluated, constraints.
3. Defining a framework for the activity and an agenda for identification.
4. Developing an analysis of risks involved in the process.
5. Mitigation of risks using available technological, human and organizational
resources.
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, 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 identified threats. For example: the
threat of losing money, the threat of abuse of privacy information or the threat
of accidents and casualties. The threats may exist with various entities, most
important with shareholders, 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 Boeing 747 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.
• 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.
• Risk Charting This method combines the above approaches by listing Resources
at risk, Threats to those resources Modifying Factors which may increase or
reduce the risk and Consequences it is wished to avoid. Creating a matrix under
these headings enables a variety of approaches. One can begin with resources and
consider the threats they are exposed to and the consequences of each.
Alternatively one can start with the threats and examine which resources they
would affect, or one can begin with the consequences and determine which
combination of threats and resources would be involved to bring them about.
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 organization 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 less
dependent on the formula used but are more dependent on the frequency and how
risk assessment is performed.
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 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 iterations, software projects can limit
effort wasted to a single iteration.
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.
Outsourcing is another example of risk transfer. In this case companies
outsource only some of their departmental needs. 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.