It can be said that the foundation of finance is the relationship between risk and reward. When investors assume more risk they expect higher returns. The concept of risk management is peppered throughout the world of finance and is the motivation behind the entire industry which seeks to manage risk against returns.
In this FAQ we will cover what risk management is, why it is important, and the four primary methods that both businesses and individuals use to mitigate risks.
What Is Risk Management?
Risk management is the process of identifying, analyzing, and accepting or mitigating the uncertainty resulting from some decision. In the world of finance, it is specific to the process of quantifying the potential for losses and creating hedges to reduce the likelihood of material impact from a substantial loss.
In the world of business risk management is slightly different. Robust risk management processes are critical for businesses to insulate themselves from material financial losses. Risk management techniques are also employed by organizations to reduce the chances of material disruptions to the business and protect their future as a going concern.
When considering risk management from the perspective of corporate performance management, it is important to consider the threats that might arise from legal issues, accidental and natural disasters, IT infrastructure breakdowns, and even data loss.
Why Is Risk Management Important?
Risk management plans aim to reduce the potential of material financial losses by implementing processes that reduce the likelihood of problems arising. It is important to note that risk management protocols are not necessarily designed to eliminate risk entirely, but rather reduce the impact if risks materialize.
It is critical for leaders to understand and work to actively manage potential threats to the organization. This allows all stakeholders to have confidence when making decisions that might impact the business as a whole. For example, lenders feel more confident lending to businesses with established protocols for risk management. This helps to provide them with confidence that a business is not susceptible to material financial losses.
The practice of managing risk has benefits that extend beyond minimizing financial impacts. For example, risk management is a primary component in creating safe work environments. Certain industries are riskier for workers than others and in these industries, risk management reduces the likelihood that staff might be seriously injured as a result of normal operations.
In the healthcare sector, risk management and patient safety departments are beginning to merge. This is in response to the growing need for high-quality patient care and how that relates to the financial protection of medical practices. By combining the two departments, patients can expect to receive the highest level of care, while medical providers can feel confident that they are financially insulated from malpractice suits.
The Four Primary Types Of Risk Management
There are four primary methods for managing risk. While there are many strategies that have been used to mitigate risks, these four methods remain the primary methods employed by most risk management processes.
Risk Avoidance
As the name implies this method attempts to avoid as many threats as possible by simply avoiding them. While risks can never be eliminated fully, this method places avoiding risk as its primary objective. A rudimentary example of risk avoidance is not riding a motorcycle as it is more dangerous than driving a car.
Risk Reduction
As opposed to risk avoidance, risk reduction methods accept that some level of risk will always exist and instead of avoiding entirely aims at implementing processes and procedures that reduce the likelihood of risk having a material impact. Following our same example, risk reduction would be riding a motorcycle but always wearing proper safety gear.
Risk Sharing
Risk-sharing occurs when the financial burden, or consequences, of risk are distributed across multiple parties. Probably the most common and well-known risk-sharing strategy is insurance policies. When insurance is acquired, you pay every month for financial protection against some loss. The money you pay is pooled with other insured individuals and the risk of full loss is then shared across all policyholders.
Risk Retention
In certain cases, risk is assessed and determined to be acceptable or worth the financial reward. In many cases, businesses assess the level of risks associated with a certain project or process against the anticipated savings or profit.
Risk retention occurs when the cost associated with a risk materializing is less than the financial reward. In practical application, this occurs more often than not. This is because there are many cases where risks cannot be avoided or shared. It is important to note that even though a risk may be retained, it might still be reduced.
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