Risk Management Lesson PDF

**LESSON 4. RISK MANAGEMENT** **Introduction** Risk implies future uncertainty about deviation form expected earnings or expected outcome. Risk measures the uncertainty that an investor is willing to take to realize a gain from an investment. It takes on many forms buts is broadly categorized as t...

**LESSON 4. RISK MANAGEMENT** **Introduction** Risk implies future uncertainty about deviation form expected earnings or expected outcome. Risk measures the uncertainty that an investor is willing to take to realize a gain from an investment. It takes on many forms buts is broadly categorized as the chance an outcome or investment's actual gain will differ from the expected outcome or return. It includes the possibility of losing some or all of an investment. Risk can be reduced using diversification and hedging strategies. **Risk Defined** **Risk** involves choosing among alternatives with uncertain outcomes, often linked to potential loss or harm(Aven & Thekdi, 2021). Risk is a multifaceted concept that encompasses uncertainty and the potential for adverse outcomes across various disciplines. It is defined as the obligation to bear losses resulting from unforeseen events, which can arise in contexts such as decision-making, contractual agreements, and health-related scenarios. Understanding risk requires insights from diverse fields, including statistics, psychology, and economics, highlighting its interdisciplinary nature. (Waluyo, 2022) **Reasons to Manage Risks:** - **Debt capacity.** Risk management can reduce the volatility f cash flows and this decreases the probability of bankruptcy. - **Maintaining the optimal capital budget over time.** This means that the capital budget must generally be financed with debt plus internally generated funds, mainly retained earnings and depreciation. In years when internal cash flows are low, they may be too small to support the optimal capital budget, causing firms to either slow investment below the optimal rate or else incur the high costs associated with external equity. By smoothing out the cash flows, risk management can alleviate this problem. - **Financial distress.** Financial distress---which can range from worrying stockholders to higher interest rates on debt to customer defections to bankruptcy---is associated with having cash flows fall below expected levels. Risk management can reduce the likelihood of low cash flows, hence of financial distress. - **Comparative advantages in hedging.** Many investors cannot implement a homemade hedging program as efficiently as can a company. First, firms generally have lower transactions costs due to a larger volume of hedging activities. Second, there is the problem of asymmetric information---managers know more about the firm's risk exposure than outside investors, hence managers can create more effective hedges. And third, effective risk management requires specialized skills and knowledge that firms are more likely to have. - **Borrowing costs.** Firms can sometimes reduce input costs, especially the interest rate on debt, through the use of derivative instruments called "swaps." Any such cost reduction adds value to the firm. - **Tax effects.** Companies with volatile earnings pay more taxes than more stable companies due to the treatment of tax credits and the rules governing corporate loss carry-forwards and carry-backs. Moreover, if volatile earnings lead to bankruptcy, then tax loss carry-forwards are generally lost. Therefore, our tax system encourages risk management to stabilize earnings. - **Compensation system.** Many compensation systems establish "floors" and "ceilings" on bonuses or else reward managers for meeting targets. **Benefits of Risks:** - Effective use of resources; - Promoting continuous improvement; - Fewer shocks and failures; - Strategic business planning; and - Raised awareness of significant risks. **Risk Management** **Risk management** is the process of identifying, assessing and controlling threat to an organization's capital, earnings and operations. These risks stem form a variety of sources including financial uncertainties, legal liabilities, technology issues, strategic management errors, accidents and natural disasters. **Risk management** is an arm of project management that deals with managing potential project risks. Managing risks is arguably one of the most important aspects of project management. A successful risk management program helps an organization consider the full range or risks it faces. The holistic approach to managing risk is sometimes described as *enterprise risk management* which expands risk as anything that can prevent the company from achieving its objectives. Enterprise risk management emphasized on an anticipating and understanding risk across an organization. It focuses on internal and external risk threats. **Importance of Risk Management** - Risk affects all aspects of the organization. - Increases probability of positive event. - Reduce the occurrence of negative event. **Benefits of Risk Management** - **Identity potential threat to the business.** - **Assess the business's vulnerabilities.** - **Make better decisions.** **Risk Management Process** 1. **Risk identification.** The first step to manage project risks is to identify. It needs to use data sources such as information from past projects or subject matter experts' opinions to estimate all the potential risks that can impact the project. 2. **Risk Assessment.** Once the project risk is identified, it needs to prioritize by looking at the likelihood and level of impact. 3. **Risk Mitigation.** Create a contingency plan with risk mitigation actions to manage the project risks. It needs to define which team members will be risk owners, responsible for monitoring and controlling risks. 4. **Risk Monitoring.** Risks must be monitored throughout the project life cycle so that they can be controlled. **Risk Management Plan** A **risk management plan** defines how project risk management process will be executed. It includes the budget, tools and approaches that will be used to perform risk identification, assessment, mitigation and monitoring activities. A risk management plan usually includes: - **Methodology.** Define the tools and approaches that will be used to perform risk management activities such as risk assessment, risk analysis and risk mitigation strategies. - **Risk register.** A risk register is a chart where documents all the risk identification information of project. - **Risk breakdown structure.** It's a chart that allows to identify risk categories and the hierarchical structure of project risks. - **Risk assessment matrix.** A risk assessment matrix allows to analyze the likelihood and the impact of project risks and prioritize. - **Risk response plan.** A risk response plan is a project management document that explains the risk mitigation strategies that will be employed to manage the project risks. - **Roles and responsibilities.** The risk management team members have responsibilities as risk owners. They need to monitor project risks and supervise their risk response actions. - **Budget.** A section where identify the funds required to perform risk management activities. - **Timing.** A section to define the schedule for the risk management activities. **Risk Analysis** **Risk analysis** is a qualitative problem -- solving approach that uses various tools of assessment to work out and rank risks for the purposes of assessing and resolving. Here is the risk analysis process: 1. **Identifying existing risk.** Risk identification mainly involves brainstorming. A business gathers its employees together so that they can review al the various sources of risk. 2. **Assess the risks.** In many cases, problem resolution involves identifying the problem then finding an appropriate solution. However, prior to figuring out how best to handle risks, a business should locate the cause of the risks by asking the question, "What caused such as risk and how could it influence the business?" 3. **Develop an appropriate response.** Once a business entity is set on assessing likely remedies to mitigate identified risks and prevent their recurrence, it needs to ask the following questions: "What measures can be taken to prevent the identified risk from recurring?", "What is the best thing to do if it does recur?". 4. **Develop preventive mechanisms for identified risks.** The ideas that were found to be useful in mitigating risks are developed into a number of tasks and then into contingency plans that can be deployed in the future. If risks occur, the plans can be put to action. **Qualitative Risk Analysis** **Qualitative risk analysis involves identifying threats (or opportunities), how likely they are to happen and the potential impacts. The results are typically shown using a probability/ impact ranking matrix. This type of analysis will also categorize risks either by source or effect.** **Qualitative risk analysis is the process of evaluating and rating an identified risk based on its severity and the likelihood of its consequences. The goal of qualitative risk analysis is to come up with a short list of risks that need to be prioritized above others.** **Quantitative Risk Analysis** **Quantitative risk analysis is a statistical technique to understanding financial uncertainty or risk in a project or business venture. It uses numerical values and complex data to determine the probability of a specific event and the potential impact that event could have on the organization** **A quantitative assessment is a risk analysis performed with a focus on numerical values of the risk present. The quantitative risk analysis allows you to determine the potential risk of a project. This can help to decide if a project is worth pursuing.** **Benefits of Quantitative Risk Analysis.** - **Objective assessment. Objectives estimated help ensure that all parties have the same understanding of the projected risks.** - **Detailed information. A quantitative assessment breaks down a project by the expected cost of each potential risks. This allows to focus reduction efforts on the risks deemed "most likely" or most costly".** - **Client confidence. When presenting a project assessment to a potential client, the specificity of a quantitative assessment may provide more confidence because there is little room for misinterpretation. By providing the client with a specific number regarding potential financial risk, they can more confidently make their decision about the proposal.** - **Improved decision making. By creating risk assessment with objective measures, involves in decision making have an accurate assessment of potential risks. This can help to make the best decision for the company.** **Importance of Quantitative Risk Analysis** **Below are some general benefits of using quantitative risk analysis in an organization:** - **Provides numerical data. Quantitative research relies on empirical assessments to provide specific numeric values associated with risk.** - **Facilitates objective decision making.** Quantitative risk analysis eliminates ambiguity and facilitates more objective decision-making by providing a clear, numeric picture of the risk landscape. It reduces the element of subjective bias that can be associated with qualitative methods, leading to more rational and robust decisions. - **Helps in risk prioritization.** Quantitative risk analysis assists in prioritizing risks based on their potential impact on your organization\'s objectives. Quantifying risks enables you to focus your resources on the most significant risks first, ensuring a more efficient and effective risk management strategy. - **Enables financial planning. This method also assists in financial planning by quantifying the potential impact of risks. It can help determine the contingency reserves needed for identified risks and supports cost -- benefit analysis for proposed risk mitigation strategies.** - **Enhances stakeholder communication.** Quantitative risk analysis provides a common language of \'numbers\' that enhances stakeholder communication. It allows for clear, precise communication about risks and their potential impacts, which can help gain stakeholder buy-in for necessary risk management actions. Numbers will be the starting domino in securing that buy-in. It's followed by the assessment of the risk with factual statements of treating the risk. If you address specific risks early, you will help to ensure a greater return on treating the risk. Therefore, it is the opening line for organizational review. - **Supports continuous risk monitoring.** Quantitative risk analysis supports continuous risk monitoring by providing a baseline for comparison as new data emerges. This can help you to identify trends, track risk mitigation effectiveness, and support adjustments to risk management strategies as needed. **Risk Response Planning** **Risk response planning** is a crucial step in the project risk management process. It involves developing strategies to address identified risks and reduce their impact on project objectives. Effective risk response planning can help ensure project success and minimize the likelihood of negative outcomes. **Four Primary Risk Response Strategies:** - **Risk avoidance.** Risk avoidance involves taking action to eliminate a risk entirely. This strategy is typically used when the risk is deemed too high and the potential impact is too great. For example, if a project involves building a structure in an area prone to earthquakes, the risk of seismic activity may be deemed too high, and the project may be relocated to a less seismically active area. - **Risk Transfer.** Risk transfer involves transferring the risk to another party, such as an insurance company or subcontractor. This strategy is typically used when the cost of addressing the risk is too high or when another party is better equipped to manage the risk. For example, if a project involves shipping goods overseas, the risk of damage or loss during transportation may be transferred to a shipping company or insurer. - **Risk Mitigation.** Risk mitigation involves taking action to reduce the impact of a risk. This strategy is typically used when the risk cannot be entirely eliminated or transferred. Mitigation strategies may include developing contingency plans, adding safety features, or conducting additional testing. For example, if a project involves building a structure in an area prone to flooding, mitigation strategies may include raising the structure above the floodplain or adding flood barriers. - **Risk Acceptance.** Risk acceptance involves acknowledging the risk and accepting its potential impact. This strategy is typically used when the risk is low or when the potential impact is deemed acceptable. For example, if a project involves launching a new product, there may be a risk that the product will not be successful. However, if the potential impact of this risk is deemed acceptable, the risk may be accepted. **Risk Monitoring and Control** **Risk monitoring and control** is a crucial process in project management that involves identifying, analyzing and responding to potential threat or opportunities that may affect the project objectives, scopes, schedule, budget or quality. **Risk monitoring and control** refers to the process of continuously identifying risks and establishing best methods of dealing with those risks. **Importance of Risk Monitoring:** - Minimizes risks by identifying and ensuring there are defenses sufficient to prevent it; - Mitigates the effects of risks of various types by having procedures in place to take action once an event arises; - Provides a clear picture of the risk landscape which in turn allows the company to be proactive rather than reactive; - Promotes accountability by recording and defining clear steps to mitigation; - Creates transparency and inspires trust in staff and stakeholders; - Utilizes historical events allows to learn from past failures to improve future mitigation; and - Allows for growth by minimizing losses to risk of various types, from natural disaster to fraud. **Types of Risk Monitoring:** - **Voluntary risk monitoring.** When the risk monitoring process isn't legally required but is a key part of risk management strategy. - **Mandatory risk monitoring.** Companies may be legally required to monitor risk based on the vertical they operate in. **Risk Monitoring Tools and Techniques** Risk monitoring is only possible if there is a data of risk strategy and challenges. The two risk monitoring methods used are to either continuously monitor risk in real time or to review it regularly. Most companies combine both methods to ensure risk strategies are effective. Techniques that can be utilized include: - **Risk assessment and reassessment.** This allows to reach conclusions from the risk monitoring process which ought to inform the organization's strategy. - **Risk auditing.** These audits will examine defined responses and other defenses and identify any need to update them. - **Trend analysis.** Looks into risk trends as well as the variance between expectations and results, so you can automatically flag any need for urgent action to improve processes. - **Risk responses.** A term to describe defined processes that trigger once a risk has been identified or a threshold has been crossed. - **Risk transfer.** Such a technique will transfer the risk to an external stakeholder or a different internal department. A common methods of risk transfer is enabled through risk monitoring are insurance policies, where third parties take on the risk in exchange for insurance premiums.