Meaning of Risk Management
Risk management is a process of identifying and mitigating risk factors that pose threat to the life of the business organization. It is a broader term of management that first detects business risk, analyzes and accordingly responds to it effectively, and finally reviews the control measures taken to overcome such risk denominators. The risk management system of business is a continuous and disciplined approach that assists in dealing with market risks. It is a crucial tool that creates a safe working environment for both staff and clients engaged with a business enterprise. Risk management safeguards the company from unforeseen and detrimental events in the future, thereby ensuring the long-term continuity of the organization.
Every business operating in the market faces distinct types of dangerous and unexpected events which may even lead to the permanent closure of its operations. Risk is something that cannot be separated from the world of investment. It is a fundamental thing that needs to be undertaken by the investor for attaining growth, profit, prosperity, and development. Proper study and planning are a must for enhancing the earning potential of businessmen and minimizing their exposure to a number of financial risks. The financial risk may be in form of bankruptcy, capital market volatility, recession, higher inflation, etc. Therefore, businesses of all sizes be it small, medium, or large practice risk management for controlling all unforeseen and unfavorable events.
Types of Risk Management
Various types of risk management approaches are as discussed below: –
Risk avoidance simply means avoiding all such activities which may contain risk. It is a risk management approach that eliminates activities, hazards, and exposures having a negative effect on organizational assets. This methodology in order to minimize the vulnerabilities carrying threats does not perform risk involving tasks. Risk avoidance can be attained via proper policy making and procedure, training, and technological implementations.
For ex. If a father knows about his son’s reckless driving and is worried about road accidents, he can ask his son to stop riding the car. This will minimize the accidental risk as an activity involving risk is no longer performed.
Risk transfer involves the transfer of risk from one party to another party who is willing to take the risk. It is a risk management and control methodology in which there is a contractual shifting of pure risk among parties. Here, the third party assumes the liability of another party in return for some periodic payments. The transfer of risk may take place among persons, from persons to insurance corporations or from insurers to reinsurers.
For ex. The purchase of an insurance policy by an individual is the most common example of risk transfer. Insurance policies provide protection to individuals against financial risk. When car insurance is purchased, then the insurance companies in return for periodic payments from the party assumes distinct specific risk concerned with the car.
A combination strategy involves combining more than one business activity for bringing down the ill effects of overall risk. A person who is engaged in one type of operation has more chances of exposure to financial risks as compared to one involved in multiple business operations. In multiple operations businesses, a loss arising from anyone’s activity can be settled off from any other activity offering profits to a business enterprise.
For ex. An investor invests their funds in a portfolio comprising multiple types of securities in the market. This is done to minimize the risk arising from failure of any one security which is settled with profits generated by other classes of securities.
Loss control is a risk management technique that makes attempts to reduce the overall chances of loss occurrence or quantum of loss. It means acting proactively for bringing down the loss arising out of accidents, injuries, and property damage. Loss control requires incorporating the changes in processes, operating policies, and practices of business for avoiding instances of losses. For practicing this methodology, business managers join hands with insurance specialists and consultants for managing the advertising effects on the financial health of the business enterprise. Some of the effective measures of loss control are: properly assigning duties and responsibilities, inspections and audits, reporting of accidents followed by investigation, reviewing claims data, and developing the right communication network.
Risk sharing is also termed as ‘risk distribution’ under which the overall risk is distributed among persons, teams, departments, or entities. It is a risk-averse technique where each member within group is allocated profits and losses related to business activity on the basis of a predetermined formula. All persons or entities undertake the liability arising out of financial risks equally as per the decided ratio. This way the adverse effects of risk on one individual due to diversifying it among many others.
Risk-retention involves taking the responsibility to face risk itself by an individual or organization instead of transferring it to some other party. A business retains the risk when it has done nothing for avoiding, reducing, or transferring it. A self-insurance reserve fund is established by an organization for paying for the losses it has incurred. This strategy is generally implied by a business when the cost of insurance payments or one required to transfer risk to a third party is much higher than the self-insurance’s cost.
Importance of Risk Management
Various importance of risk management are as discussed in points given below: –
The major role played by the risk management technique is that it reduces the uncertainties for business enterprises. Uncertainty of any type proves bad for the organization resulting in deteriorating circumstances. Risk management works toward identifying all such scenarios that bring potential risk to the business. The risks can be dealt with more effectively using safety steps by companies when they are already aware of them. Managers are able to analyze and make more logical decisions after identifying them which results in the proper handling of potential business risks. Market risk, operational risk, credit risk, and reputational risk are four major types of risk with which every enterprise needs to be aware.
Helps in better planning
Proper planning and the right decision-making are crucial for achieving desired business success. An organization should essentially incorporate countermeasures in its plans for dealing with unforeseen events bringing adverse effects. There are higher chances of failure in each thing a business carries if risk management is completely ignored. Risk management helps in minimizing the effects of unforeseen events on business operations. It detects the possible threats, reduces their chances of occurring, and enables you to protect your strategies in presence of right countermeasures and precautions.
Minimize expenses and losses
Business risks have a great role in influencing both expenses as well as the income generated from their set of operations. Any unforeseen event or mishap negatively influences the overall organizational productivity and ability to serve clients which results in income losses. If all such events can be anticipated at an early stage, then they can be tackled properly by making the right strategies in advance. The risk management approach helps in keeping track and monitoring all these types of situations, bringing losses to the business thereby dealing with them in a more effective manner.
A risk manager pays great attention to health and safety aspects within the business environment. They actively look for problem areas and timely address them. Data analytics is implemented by them for knowing loss and injury trends and taking correctives steps for avoiding them from reoccurring. Employees are benefitted from this approach whether they are performing duties in a physical work environment like construction sites or are office employees. A safer work environment enables work with more focus and better productivity.
Safeguard company resources
Risk management techniques not only work toward detecting potential risks but also saves company resources to a great extent. When businesses have better plans and policies then they can deal with risk in a more effective and quick manner. This sort of action enables businesses in saving their time, money, and other physical resources. Employees are also able to give more time to their allotted duties which enhances the overall business productivity.
Enhance the brand reputation
Implementation of risk management strategy within the organization conveys a positive message in the market. Customers feel more assured in doing business with companies that are proactive and professional in dealing with risks. It also boosts the employee’s morale by offering them a work environment in a resourceful and responsible corporation. Having risk management depicts that the organization follows high standards and is reputable. Business becomes robust and reliable enabling them to continue their operations even when a disaster strikes it inevitably.
Benefits the business culture
Proper risk management provides the right business culture for every party associated with it either directly or indirectly. Various parties involved are key decision-makers, risk managers, executives, and frontline employees. A mindset of safety and prevention is built among workers regarding the organizational culture. All these deliver a positive image among the public in the market and set expectations of higher performance.
Examples of Risk Management
Commonly used risk management examples are listed below: –
It is a common type of risk that is present across all types of industries. Suppose a farmer growing rice may face a risk where the rice price may go down till the time it reaches the market. In order to deal with this risk, farmers enter into an early contract for mitigating risk under which rice crops will be sold at a fixed price.
Compliance risks can turn out to be a huge risk for institutions which makes maintaining regulatory compliance a key aspect for them. Banking firms mitigate these types of risks by implementing control measures in their procedures, processes, and technologies.
Elimination of contract risk
There can be external risks to a company operating overseas in which the investor puts his money. An investor may face big threats leading to huge losses due to the fall in the foreign exchange rate. In order to deal with such risks, a contract in USD is made by investors for keeping themselves safe.
Safety risks adversely affect the operations of the business and need to be taken care of on a regular basis. An airline industry avoids safety risks by performing audits of maintenance processes and procedures for latent human error. In presence of a risk management system, all these types of risks can be effectively handled.
Liquidity risk is the very adverse situation in which a business or an individual is not able to meet its short-term obligations. The assets can’t be converted into cash by investors without giving up capital portion or income as a result of an inefficient market or lack of buyer’s presence. Small scale business avoids such risks by reducing upfront investments with techniques like instead of purchasing, they prefer renting locations.
Information security risks refer to threats associated with the use of information systems and the environment within which these systems operation within business. These risks are mitigated by the technology department by scanning every incoming mail for spam. Training is provided to employees for detecting suspicious emails and how to report them immediately.