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Risk Management – The need for formal education

By Michael Vincent

28 December, 2006

Risk management is the emerging management philosophy of tomorrow's successful company.  We are slowly eliminating the concept linking risk management and insurance.  Industry has been restructuring for over a decade and the emphasis has been on increasing efficiency and productivity whilst downsizing in terms of employee numbers.

 

A point has now been reached where all the benefits of restructuring are at risk unless the traditional management structure can embrace the new management paradigm of risk management.  The concept of project management overlaid with the principles of risk management enable an entity to manage effectively with a minimum of resources.  Failure to embrace the new paradigm will see companies shrivel and die because the restructuring has left no room for growth when opportunities allow.

 

Risk management is the ability to identify, measure and finance the risks facing an entity in an effective way to ensure corporate growth and survival.

 

What do we mean by risk management?

 

Risk is a dynamic concept that requires identification and understanding.  It requires not just a professional and analytical approach, but also imagination and innovation.

 

Boards of Directors and risk managers should consider: -

 

Is risk good or bad?

 

How do we identify risk?

 

Should we avoid risk?

 

Should we transfer risk?

 

Should we retain risk? or

 

Should we manage risk in the most efficient manner?

 

Risk must be identified, understood, managed and controlled.

Risk, as far as many financial managers are concerned, is the cost of insurance and no more.  Finance and treasury managers have traditionally focussed on the cash flows and cost of managing risk; it can either be managed in terms of financial risks (interest rate, risk, foreign exchange risk, liquidity risk, price risk, and credit risk) or in terms of operational risks via the insurance process.

 

The traditional insurance approach is no longer valid as the only alternative to managing and financing risk.  Finance directors and corporate treasurers are becoming increasingly aware that they must become involved in the "big picture" in terms of risk management.

 

Professional development in the treasury area is focussing their attention not just in terms of cost of managing financial risks, but also the need to focus on the increasing cash flows of managing other risks.

 

If management can control risks and their cost in a more efficient manner then the organisation will suffer fewer (potential) losses which will increase the benefits or profits to be gained from operations.

 

This century has seen an increasingly difficult business environment.  Corporations have experienced difficulties in maintaining profitability in a increasing recessive environment and traditional management practices have been under review in an endeavour to introduce more efficient ways of managing the underlying business.  Old approaches can no longer be tolerated.

 

Risk Defined

There is no single definition of risk.  It is traditionally defined as the uncertainty concerning the occurrence of loss.

Risk can be categorised as:

 

Objective Risk;  the relative variation of actual loss from expected loss.  It can be statistically measured.

 

Subjective Risk;  the uncertainty based on a person's mental condition or state of mind.

 

The chance of loss is considered to be the probability that an event will occur.  It can be categorised as: -

 

Objective Probability;  the long run relative frequency of an event occurring based on an infinite number of observations and no change in underlying conditions.

 

Subjective Probability;  an individual's estimate of the chance of loss.

Peril and hazard should not be confused with the concept of risk discussed earlier.

Peril is defined as the cause of loss whereas a hazard is a condition that creates or increases the chance of loss.  There are three types of hazard: -

Physical hazard;  a physical condition that increases the chance of loss.

Moral hazard;  dishonesty or character defects in an individual that increases the chance of loss.  It is usually the result of dishonesty.

Morale hazard;  the carelessness or indifference to a loss because of the existence of insurance.

There are three major categories of risk: -

 

1. Pure and Speculative Risks.

Pure risk is a situation where there is only the possibility of loss or no loss.  There is usually no opportunity to profit from the loss. 

Speculative risk is a situation where either a profit or loss is possible.  It includes commercial and financial risks.

 

2. Static and Dynamic Risks.

Static risks occur because of irregular actions by nature or individuals.

Dynamic risk is associated with a changing economy.

3. Fundamental and Particular Risks.

Fundamental risk, such as inflation relates to the entire economy or a large number of persons or groups within the community.

Particular risk affects generally individuals and not the entire community or country.

Risk Management further Defined.

The introduction of risk management as a professional discipline means that a more concise definition of the process is required.

Risk management is a discipline that enables people and organisations to cope with the possibility that future events may cause some harm.

It is the identification, analysis and economic control of those risks that threaten the balance sheet (assets and liabilities) or earning capacity of the organisation.

 

Identification of risk is the most important process.  All risks that threaten the organisation must be identified.

 

Managing risk must have a significant impact on maximising profitability by protecting and enhancing an organisation's bottom line!

Methods of Managing Risk

Five methods are used to manage risk: -

1. Avoidance. This method can result in opportunity loss.

2. Retention. Risk retention can be both active and passive.

 

Active risk retention is a conscious decision to retain risk, such as self- insurance. 

Passive risk retention is the retention of risk due to ignorance, indifference or laziness.

 

3. Non insurance Transfers. This technique results in risk being transferred to a party other than an insurance company.

  

4. Loss Control. Loss control consists of activities undertaken by the organisation to control the frequency and severity of losses. It has the objective of loss prevention and loss reduction.

 

5. Insurance. This has traditionally been seen as the most practical method of handling risk. It includes risk transference, the pooling technique and the law of large numbers in its application. Cost of insurance can be excessive and many multinational corporations are continually seeking new methods of cost reduction.

 

Who Should Manage Risk?

 

 

The optimum place for risk to be managed is at the point that the exposure to risk occurs.  Most risks faced by a corporation are best managed in a decentralised way within a centralised policy coordinated by a professional risk manager.

 

The risk manager should be a coordinator of the various tasks associated with the identification, analysis and economic control of those risks which threaten the assets or earning capacity of the organisation.

 

The risk manager should provide loss prevention methods, techniques and resources to the line manager to enable the associated risk to be controlled and managed.

 

We cannot all be experts in every area of the technical and financial aspects of a business.

 

Risk should be managed as a whole using a number of managers as a team.

Components of Risk Management

The risk management process must integrate, impact, inform, interpret and influence practices within the organisation.

 

A proactive approach to risk management is not just a reliance on good practice, or the creation of systems.  It is a process of managing risk.

 

The basic components include:

 

1. Risk Management Policy.

 

The policy should be approved by the Board of Directors and should outline the broad objectives to be adopted in the risk management process.

 

It should consider the role of risk manager, its level of seniority and the level to whom the risk manager reports.

 

2. Risk Management Process.

 

This must define the basic steps to be followed is risk is to be managed.  Risk identification such as physical inspection, check lists, flow charts, hazard indices and hazard operability studies to name a few.

 

This is not a static concept.  As discussed earlier, risk is a dynamic concept that operates in a circular fashion.  It is an ongoing process.

 

3. Administrative Support for the Risk Management Process.

 

The risk management process cannot operate with inadequate resources.

 

Risk Measurement.

Risk Measurement provides information to enable management to make more informed decisions about actions to be taken. It should measure the total impact of risk on the organisation including the number of events, their cost and frequency. The traditional measure of risk is in terms of frequency and probability. The analysis must be understandable.

 

SUMMARY:

  

The brief discussion above high lights the risks that a modern corporation can be faced with.  Failure to address and manage risk will result in corporate demise.  The key to ongoing risk management is the education of risk professionals to ensure survival of corporations into the future.

About the Authors

Department of Accounting and Finance

Faculty of Business and Economics

Monash University

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