risk management definition
The Importance of Risk Management in Modern Organizations
The systematic approach to risk management is a subject whose importance is acknowledged by a wide audience that includes stakeholders such as corporations, small and medium-sized enterprises, investors, capital market participants, public institutions, governmental agencies, policymakers, regulators, non-governmental organizations, the global civil society, and educational entities (universities or research institutions). This contribution aims to underline the specific tools addressing the risk management process, as well as the standards and frameworks that are available for organizations, regardless of their nature (public or private) and of the details of their activity, structure, or size. The authors act as investigators in the field of risk management and propose a structure of risk information that might act as a mapping tool for stakeholders in the field of risk management, a profiling framework using different types of variables corresponding to relevant variables that have a potential impact on the risk management system and can drive forward its success.
Risk management serves at the core of any organization, including governmental agencies, multinational corporations, the public sector, industrial companies, and smaller or medium-sized enterprises. Regardless of the magnitude of risk, its nature or probability of occurrence, risk triggers an adverse impact on operational efficiency, corporate reputation, economic added value, environmental responsibility, safety, security, financial performance, or community development. Accounting for the crisis events that occurred during the last decades and acknowledging the current turbulent environment heralding an increase in the level of uncertainty and complexity, risk management is nowadays an indispensable tool that supports and underpins the development of any organization.
Risk is the likelihood of loss versus the response to the hazards using the utility of the object at risk. The making effect is a confluence of two generic questions: is loss possible/envisaged and, if so, what is the likelihood and potential impact/damage to the object? The term consequence may also be used to describe the outcome, or potential outcome, of certain events, and the term damage is used to describe the consequences of certain accident types. These terms are particularly relevant in relation to the dynamic industrial sector, particularly the safety of systems and processes, and the protection of individuals undertaking the economic activities associated with the sector in question. The safety cycle comprises hazard identification (i.e. acknowledging that a certain factor could escalate into a dangerous situation), risk assessment (i.e. the process of evaluating the risk arising from a hazard), and response to the risk itself. The protection of the operator can be supported by different barriers of a prevention or control nature, including the reduction of the adverse effects due to an accident to an acceptable level of harm for personnel protection and the reduction of consequences.
Risk management (RM) is the identification, assessment, and prioritization of risks (defined in ISO 73:2009 as the effect of uncertainty on objectives), followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unexpected events or to maximize the realization of opportunities. The actual risk management approach may differentiate between individual entities, whether over the business cycle or at a significant point in time for relevant key risks, or generally across the economy, such as ‘worst-case’ considerations given the potential for contagion of certain risks at times of financial instability and their impact on confidence. Responses to risks typically include acceptance, avoidance, reduction, transfer, and exploitation of opportunity.
Effective risk management can benefit organizations in a number of ways, not least helping to ensure their survival and the growth of their revenues. This Clear Thoughts considers those various factors and provides guidance for any organization wishing to develop a useful and practical risk management system. It is acknowledged that in most organizations subject to this guide, the risk management framework operates as a process within the wider system of internal control. A useful introduction explaining the relationship between the risk management and corporate governance perspectives can be found by reading the Institute of Risk Management’s “Executive Summary on Risk Management and Corporate Governance”. Corporate governance already obliges management to report to stakeholders on risk management by means of directors’ reports. Directors’ duties require the disclosure of risks of significance facing a company. The risk management process assists directors in discharging their legal duties. Determining the nature and extent of a risk will enable the board to take mitigating action.
A standard risk management framework can deliver many business benefits if it is implemented correctly. In most middle market businesses, stakeholder time is limited and resources are under constant pressure. In those circumstances, it can be difficult for senior management to give priority to a risk management process that does not appear to deliver a bottom line advantage. Spending time solving problems that are not yet apparent is often seen mistakenly as time wasted. Directions from senior management to “do more with less” do not reference sensible risk management suggestions that will ultimately enhance strategic decision making and protect stakeholder investment. Implementing a good risk management process not only fulfills both legal duties and corporate governance guidelines, it can also help prevent or mitigate the response to an often difficult-to-quantify black swan event. Where shareholders are concerned only with the bottom line, where is the incentive to spend money making the business more robust in the future?
These are the questions we now address in this section by discussing what are the best practices and strategies for effective risk management in modern organizations. One of the first principles and approaches to effective risk management is for an organization to change its risk culture and commitment from ‘managing risks using a departmental-centered and centralized approach’ to an enterprise risk management culture and shared responsibility across all departments and management levels within the organization. In other words, a pervasive and participative risk management culture and engagement should be cultivated. One of the challenges to be encountered with this shift is the management of the increasing complexities of diverse risks that now permeate the product, economic, competitive, and regulatory landscapes in which many organizations now operate.
Having established the premise that risk management is an essential dimension of the domain of operations or activities within an organization, the next pertinent question is: what are the best practices and approaches or strategies to ensure an effective deployment and execution of risk management functions within an organization? In other words, how can an organization acquire and execute the capacity or capability to engage in purposeful, proactive, intelligent and systematic deployment of skills, knowledge, and processes to change the risk character of decisions and confront uncertainties in the achievement of its goals and social responsibilities?
We begin with a very simple situation in which only an empirical analysis can inform one’s opinion (for subjective judgment would not sufficiently humble): an insurance company is considering offering a terrorism insurance policy for the first time. Clearly, this is a peril that cannot be modeled or statistically described, although data from prior terrorist incidents could be used to model the damage that any given attack might cause.
The remainder of the chapter discusses some real-world applications of the risk management tools addressed above. Since many of these applications are complex, the specific methods of calculating projections of risk parameters are omitted. The case studies below should give readers an appreciation for the types and the range of potential applications of a formal risk management system. They should also help to indicate both the data and the scientific assumptions which are required in order to apply such techniques to the real world. Our framework is a combination of subjective, empirical, and theoretical analyses, so that the use of formal statistical models, such as estimation of risk measures or capital allocation exercises, is seen as one small part of the overall procedure, albeit a crucial one.
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