What are the key elements of the risk management process? It’s a great question — and an important one — since crafting an effective risk management program protects a company’s reputation and can even give it a competitive edge in the marketplace.
Like any other worthwhile business activity, risk management requires a process with a clear purpose, reliable inputs, well-designed activities and value-added outputs. Here’s what to consider when evaluating your company’s enterprise risk management (ERM).
The key elements of a risk management program include:
These elements of a risk management program are flexible. They have to be, because strategies, organizational structures, operating philosophies and risk profiles vary in complexity across industries and firms.
This article describes the steps in the process — your job is to put them into action as soon as possible.
Step One: Identify Risk
An enterprise risk assessment process identifies and prioritizes a company’s risks, providing quality inputs to decision makers to help them formulate effective risk responses, including information about the current state of capabilities around managing the priority risks.
Risk assessment spans the entire organization, including critical business units and functional areas. Effectively applied using business strategy as a context, risk assessment considers attributes such as:
Step Two: Source Risk
Once priority risks are identified, they are traced to their root causes. If management understands the drivers of risk, it is easier to design risk metrics and proactive risk responses at the source. Will this step present challenges? Almost certainly. Overcoming them is key to success.
Step Three: Measure Risk
There is an old adage that says, “If you can’t measure something, you can’t manage it.” Because not all risks are quantifiable, increasing transparency by developing quantitative and qualitative risk measures is common practice.
Measurement methodologies may be simple and basic. Here are some examples of how to measure risk:
- Risk rating or scoring
- Claims exposure and cost analysis
- Sensitivity analysis
- Stress testing
- Tracking key variables relating to an identified exposure
More complex methodologies for companies with more advanced capabilities could differ — and might be more complicated. But remember: ignoring risk won’t make it go away. Other risk management methodologies might include analyzing these complex factors:
- Earnings at risk
- Rigorous analytics that are proprietary to the company
- Risk-adjusted performance measurement
- Examining value at risk
Step 4: Evaluate Risk
Based on the priority risks identified, their drivers or root causes and their susceptibility to measurement, the next step requires that management choose the appropriate risk response.
There are four categories of risk responses:
These responses can be applied to groups of related risks consisting of natural families of risks that share fundamental characteristics (like common drivers, positive or negative correlations, etc.) consistent with a portfolio view.
The organization first decides whether to accept or reject a risk based on an assessment of whether the risk is desirable or undesirable. A desirable risk is one that is inherent in the entity’s business model or normal future operations and that the company believes it can monitor and manage effectively. An undesirable risk is one that is off-strategy, offers unattractive rewards or cannot be monitored or managed effectively.
If an entity chooses to accept a risk, it can accept it at its present level, reduce its severity and/or its likelihood of occurrence (typically through internal controls), or share it with a financially capable, independent party (typically through insurance or a hedging arrangement).
Step 5: Mitigate Risk
Depending on the risk response selected, management identifies any gaps in risk management capabilities and improves those capabilities as necessary to implement the risk response. Over time, the effectiveness of risk mitigation activities should be monitored.
Step 6: Monitor Risk
Models, risk analytics and web-enabled technologies make it possible to aggregate information about risks using common data elements to support the creation of a risk management dashboard or scorecard for use by risk owners, unit managers and executive management.
Dashboard and scorecard reporting should be flexible enough to enable the design of reports to address specific needs, including reporting to the board of directors. Examples of dashboard reporting, which often features “heat maps” or “traffic light” indicators, are provided in the Application Techniques of the COSO Enterprise Risk Management Integrated Framework. Monitoring also includes activities of an internal audit function.
The purpose of the risk management process varies from company to company, e.g., reduce risk or performance variability to an acceptable level, prevent unwanted surprises, facilitate taking more risk in the pursuit of value creation opportunities, etc. Regardless of purpose, the good news is that a large body of knowledge on the risk management process is readily available so that companies can adopt a process view that best fits their circumstances.