The Importance of Risk Management

Every day, in many different aspects of our lives, we encounter risk. Risk is an unavoidable fact of life, and the consequences can be grave, depending on what type of threat is associated with the risk.

Risk management is most often associated with businesses. Each business deals with unexpected and harmful risks that can have a dramatic effect on the profitability and viability of a business. But, risk management can just as easily apply to individuals, too. As people, we’re faced with risks on a daily basis, and we must manage those risks effectively.

Of course, we can also choose to ignore these risks, instead, leaving the potential for a harmful outcome to chance. But, when we do so, we bring new risks into the fold, too, and these risks may have a profound effect on you and the people you love.

Today, we’re going to learn more about risk management and the importance of risk management, so you’re able to make clear decisions about the risks you’re willing to tolerate, both personally and professionally.

What is Risk Management?

Risk management involves identifying, understanding, and controlling the threats that are present in any landscape. Risk management can be applied on an individual level, but it’s most commonly associated with businesses and organizations.

For individuals, an example of the risks you face could include occupational hazards, sickness, disease, and natural disasters, among other things. For example, if you’re a carpenter, you face injury risks each day on the job. Or, if you live along the Florida coast, the threat of hurricanes is a risk that you face.

For businesses, risk typically stems from places like financial uncertainty, strategic error, accidents, security and data-related hazards, and legal liabilities. As we grow increasingly reliant on technology and cloud-based services, threats associated with digital property, like proprietary information, customer data, and intellectual property have become significant risks that need to be appropriately managed.

Every individual and corporation faces threats from harmful and unforeseen events that can have significant financial, personal, and professional implications. The field of risk management aims to help prepare people and organizations for these risks by minimizing the risks and the costs associated with them from the outset.

Risk management is critical to every business and individual because it can help them avoid dangerous or uncharted territory, which has the potential to lead to a negative outcome for the person or company. At the same time, an effective risk management plan also helps to insulate the organization from the worry and concern associated with risk, so they can focus on their business more fully.

A comprehensive risk management plan should encompass all of the various risks and events that could occur, that way the company or individual is insulated from potential negatives on all fronts, allowing them to operate more confidently in the process.

Field experts regard a system approach to risk management is the best practice for protecting a business from risk. First, the risk is identified, and then that risk is documented down to the finest details. From there, concerned parties complete the risk management and mitigation process by reviewing the situation critically, and creating the policies and structure necessary to address the concern.

Risk management is such a critical process that it should be incorporated into the objectives of a business. For each new undertaking, project, or process, all of the associated risks must be carefully considered. Careful risk analysis invites fewer surprises, allowing companies to focus on their objectives with less fear of the risks associated.

Major companies and organizations that are especially successful tend to only undertake calculated risks. In these cases, the businesses have decided that the competitive advantage that can be gained by inviting the risk is well worth the potential downsides.

In these global times, major companies like Google or Amazon are consistently undertaking challenging projects that carry a great deal of risk. Part of the reason why these companies are so successful is that they’ve effectively managed the risks associated with their expansion into the global marketplace.

What are the Benefits of Risk Management?

A comprehensive risk management plan will help a business protect their future, while also saving them money in the process. By understanding and controlling the risks associated with the business, stakeholders can operate with more confidence when navigating the potential threats to the business. A strong direction with regard to risk management can also help a company reach goals outside of the risk management space, as well.

Beyond saving money, there are other significant benefits associated with risk management.

Identify risks that are easily overlooked. For many businesses, the easiest risks to identify are rarely the ones that come to fruition. But, with a team of risk management experts at work, your company will be able to identify the less obvious risks which may befall the business.

Risk management is a showing of good faith. Many regulatory agencies are inclined to give the “benefit of the doubt” to businesses under investigation when that business has an in-house corporate compliance or risk management department.

Reduction of liability. Shareholders and investors are becoming increasingly concerned with the risk of litigation. A risk management team helps reduce the threat of litigation, which makes the business a more attractive investment for investors.

Provides necessary insight to the board of directors. Inside any boardroom in America, you’ll find executives that have blind spots for the risks that fall outside the area of their expertise. A capable risk management team can help to identify those risks, providing investors with fresh insight into potential risks.

Increases business stability. Risk management provides a business with stable footing from which to operate by reducing the potential for and the impact of different threats to the company. Instead of focusing on liability, management can instead focus on innovation.

Saves money on insurance premiums. A risk management team is a signal to insurers that the business is serious about managing risk and reducing the implications of such risks. In acknowledgment of this fact, insurers are more likely to extend lower premiums to you for their services.

How to Develop a Risk Management Plan

The first step in taking meaningful steps toward managing your risk is going to be to create a plan for dealing with the threats to your enterprise. While it may seem intimidating at first, developing your plan will become much more manageable when you break it down into actionable steps.

A comprehensive risk management plan will include these six steps:

  • Establish the Context
  • Identify
  • Analyze
  • Evaluate
  • Remedy
  • Review

Establish the Context

Before setting out to identify the different risks you face, it’s essential to establish the context of the situation and define clear goals. Once this is established, you can begin identifying risks and creating a plan for dealing with them.

First, understand the circumstances that will surround the entire risk management process, and agree on what criteria you’ll use to evaluate the different risks you encounter. You’ll also want to create the structure by which you’ll analyze all the information that must be established.

The entire process should be easy to understand and effective for all stakeholders. One of the best ways to ensure its effectiveness is to perform a SWOT analysis of a variety of situations. Where risks are identified, use the structure you’ve created to analyze the situation, and find ways to turn the threat into an opportunity.

Context becomes especially essential when you’re establishing the different stakeholders who will be affected by the threat. In this case, stakeholders could be employees, clients, government agencies, other businesses, and more. You also may have multiple stakeholders who might be affected by a single threat.

Since each of these stakeholders has different interests, needs, opinions, and concerns, it’s important that each group is involved in the risk management process.

Identify Risks

The next step in the process involves identifying the different risks faced by the business. The key to correctly identifying and addressing all the risks associated with the company requires a careful examination and a collaborative effort from the group.

Within business, there are typically four types of risks that are an issue for companies. These risks are financial, physical, ethical, or legal in nature.

Financial risks are things like a loss of funding, fraud, theft, insurance costs, fees, rising material costs, and many more. Physical threats are risks that can affect members of the organization, such as personal injuries.

Ethical risks are threats to the morality of a company, and they can cause irreparable harm to the company’s image, and to the public’s confidence in the business. Finally, legal risks involve the company’s responsibility to follow the laws, rules, and regulations of the industry that are set forth by local or state governments and regulatory bodies.

Organizations can identify the various risks at play by looking to the past and examining records of past experiences that the organization has enabled, as well as the past experiences of competitors. A discussion with all of the stakeholders involved is usually a sufficient way to gather a list of all the different risks which are in play for a specific business.

Analyze Risks

Once you have an idea of the different risks at play, you must determine what impact these threats can play for the business, and how likely they are to occur. Once you’ve identified a threat and determined it’s likelihood, you can begin estimating what impact the risk could have on the business.

The relationship between how likely a threat is to occur, and how damaging it could potentially be to the business defines the level of risk at play. From there, management can explore different ways to deal with these various risks.

The level of risk can be defined as either extreme, high, moderate, or low.

Extreme risks demand immediate intervention because the potential threat could prove devastating to the business.

High risks require action because the outcome could be damaging to the business.

Moderate risks require monitoring to ensure that they don’t become higher-risk situations. Typically, these risks can be easily tolerated.

Low risks are easy to tolerate, as the potential threats they represent are unlikely to prove damaging to the business.

Enterprises typically rely on qualitative techniques to measure risk levels. A risk matrix can be a helpful presentation device that can offer insights into the nature of the risk. This is a visual tool that allows management to set a threshold above which risk cannot be tolerated.

A risk matrix is plotted on a coordinate grid, with the y-axis representing the likelihood of the threat coming to fruition, and the x-axis representing how damaging the potential result could be to the business. Depending on how aggressive the company is, they can then determine the amount of risk they can tolerate.

Evaluate Risks

Once risks have been identified and analyzed, it’s time to determine whether or not a particular risk is acceptable or not. This step accounts for the following:

  • The possible outcomes of the risky activity
  • The losses that may result from the risk
  • The benefits and opportunities the risk presents
  • How much control an enterprise has over each risk

Acceptable risks are ones the business is able to absorb without severe consequences. These risks require constant monitoring and review to ensure that the threat remains as a tolerable level. Most companies will consider a risk acceptable because of reasons like:

The risk level is low enough that the potential benefits outweigh the costs of managing the risk.

The level of risk is so small that it isn’t worth investing the time and money into managing it.

The opportunities presented are so much higher than the threats the risk poses.

Meanwhile, unacceptable risks are those that can deal a severe blow to the health of a business. These risks aren’t worth the opportunities inherent to the risk, and they must be managed in a timely fashion to prevent them from occurring and affecting the business.

Remedy Risks

There are several ways of dealing with the various risks that your business may encounter. Risks can be reduced or avoided, shared among stakeholders, or retained. These risks can be avoided when action is taken to prevent potential pitfalls from occurring.

During this decision-making process, the idea is to strike a balance between the cost of remedy and the effect it will have. Businesses can remedy their various risks by:

  • Laying out the options available for treating the risk
  • Selecting the best solution for dealing with the risk
  • Preparing a plan to remedy the risk
  • Implementing the plan

Most risks are shared among stakeholders via how profits and losses of the company are divided. This allows the various stakeholders to share the brunt of the impact from a risky situation.

This is a popular way to deal with risk in our increasingly global society. As businesses face pressure to expand into new markets, the risks of expansion are shared among stakeholders, who are then able to take a collaborative approach to share the risk and mitigate their impact.

Review the Results

Once you’ve prepared and implemented your plan, it’s essential to gather as much information as possible regarding your plan so you can garner meaningful insight into its effectiveness.

After all, remedying the situation typically calls for an expenditure of time and money, so you’ll want to know that the effort you’ve put forth is working. Further, you’ll want to make sure that the plan you’ve implemented is adequately mitigating the risk at hand.

Once you’ve reviewed the results, you should have the insight you need to either maintain the status quo or return to the drawing board so you can implement a plan that will better address the risk at hand.

Provided that your plan is working well, you’ll want to continue to periodically review the situation to ensure that the risk is still being properly managed and doesn’t have the potential to damage you or your company.

Risk Management Methods

When it comes to the business of managing risk, there are several different accepted methods that businesses and individuals can utilize to create an effective strategy for dealing with the threats they face. The most popular ways for risk management are avoiding risk, retaining it, reducing it, or sharing the risk among multiple stakeholders.

Risk Avoidance

With risk avoidance, high-risk activities are avoided at all costs to prevent a threat from being realized.

Let’s use a car insurance company to illustrate the concept of risk avoidance. If you’re a person who drives a sports car and has a history of moving violations and reckless driving, an insurance company will probably decline to provide you with an insurance policy. By steering clear of high-risk customers, they are practicing risk avoidance.

Risk Retention

When a risk is retained, all of the potential threats associated with the risk are ignored because you believe that the potential risks will have little impact on you or your business.

To use our car insurance example from above, a customer who chooses to decline full coverage on their insurance policy because they have the assets and income necessary to pay for repairs in case of an accident would be practicing risk retention.

Risk Reduction

Risk reduction is also known as loss prevention, and it’s the process of reducing risk to a tolerable level.

Sticking with our insurance example, a customer who chooses a moderate level of car insurance is practicing risk reduction by hedging against the likelihood of a risk.

Risk Sharing

Risk sharing is a process by which a certain level of risk is retained while the balance of the risk is transferred to other parties.

Car insurance is a perfect example of this. When you pay your car insurance premiums, you are retaining some of the risk associated with the threat of an accident, while transferring the balance of the risk to your insurer.

Risk Transfer

With risk transfer, the entirety of risk is transferred to a third party, and you no longer bear any responsibility for the threat itself.

Life and disability insurance are a perfect example of risk transfer, as you’re transferring all responsibility for the risk to another party in exchange for the payment of your insurance premiums.

Tips for Managing Risk

The strategies above represent the best ways that you can manage the various risks you’re sure to encounter in today’s business environment. Beyond these strategies, there are also some best practices you can adopt that can help you to mitigate some of the risks you encounter.

Save for a rainy day. A generally accepted rule of thumb is that you should always have a contingency fund in the amount of 3-6 months of living expenses. Doing so helps reduce the impact of risks that could result in a loss of your job, an injury, or a hospital stay.

Diversify your portfolio. A broad portfolio with investments in a variety of markets is key for riding out any market irregularities or short-term losses in any one particular market. As the saying goes, don’t put all your eggs in one basket.

Put your health first. Sadly, untenable medical bills are the leading cause of bankruptcy in America. Obviously, there are certain health situations that are impossible to plan for. But, by regularly visiting the doctor, you can stay ahead of any issues and ensure that you’re in good health.

Be honest with yourself. When it comes to managing risk, you must make an accurate assessment of how much risk you’re willing to tolerate. Capitalize on the strengths you have and focus on minimizing weaknesses. Without an honest assessment of your thoughts on risk, it’s challenging to create an effective risk management strategy.

Stay on the cutting edge. In today’s climate, there’s more competition than ever. To get ahead, you need to keep your skills razor-sharp and always look for ways to add new skills and experiences to your toolbox.

Keep your debt low. Credit card spending and loans can open Pandora’s Box if you aren’t careful. While these infusions of capital can be a great temporary fix to your issues, they can also become untenable quickly, resulting in a whole new slew of risks that can have serious implications for the future.

Have the right insurance. Insurance is one of the best ways to mitigate risk, and it offers peace of mind against a variety of different threats we all face each day. Medical, car, and life insurance immediately come to mind as practical necessities, and depending on your line of work; there may be other forms of insurance that make sense for you.

Cross your T’s and dot your I’s. It’s always important to do your due diligence, especially when it comes to financial matters. Before you sign your name on the dotted line, take the time to do your research and ensure that what you’re signing is in your best interest.

Why Risk Management is Important

At this point, you should have a clear understanding of the risk management process, and what the benefits of employing an effective risk management strategy are. But, there are still more reasons why risk management is important. Three, in particular, come to mind. Risk management helps you to prepare for the unexpected, protects your financial standing, and safeguards your family.

Perhaps most importantly, risk management helps you to prepare for the unexpected. It’s impossible to predict the future, but it is possible to make a fair and honest assessment of the different risks that have the potential to affect you or your business. From there, risk management allows you to take the necessary steps to safeguard yourself from these risks.

Risk management can also help to insulate you from financial risks. By having a plan in place to tackle unforeseen threats to your business or yourself, you’re able to create plans to protect yourself in the event of a catastrophically risky event coming to fruition.

Finally, careful risk management can also protect your family in the event of a major risk unfolding. If you’re laid off, injured, or worse, risk management strategies can help ensure that your family is in good hands when you’re unable to protect them yourself.

These important benefits illustrate the importance of risk management for businesses and individuals. In a corporate setting, risk management is especially important because of how much there is at stake. The business itself, management, employees, and so many more parties can all be affected by unforeseen risks and unexpected financial impacts.

Final Word

Whether you’re an individual who is looking to safeguard yourself and your family from unnecessary risk, or you’re a business owner or decision-maker that needs to insulate the business from the various risks inherent to the business environment, risk management is the most effective tool.

Effective risk management allows you to probe the marketplace for all the potential risks that may affect you and your business, and it also provides the framework from which you can work to mitigate these risks.

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