Risk management

Risk management is a key element of any management accounting role. The ability to identify risks before they arise, and then plan a strategy to deal with them is paramount. The consequences of not doing this could be business failure.

A discussion of the nature of risk and identifying risks is discussed in detail here. This page looks at the related issue of risk management.

Risk management

Management needs to manage and monitor risk on an ongoing basis for a number of reasons:

• To identify new risks that may affect the company so an appropriate risk management strategy can be determined.
• To identify changes to existing or known risks so amendments to the risk management strategy can be made. For example, where there is an increased likelihood of occurrence of a known risk, strategy may be amended from ignoring the risk to possibly insuring against it.
• To ensure that the best use is made of opportunities.

Managing the upside of risk

Historically, the focus of risk management has been on preventing loss. However, recently, organisations are viewing risk management in a different way, so that:

• risks are seen as opportunities to be seized
• organisations are accepting some uncertainty in order to benefit from higher rewards associated with higher risk
• risk management is being used to identify risks associated with new opportunities to increase the probability of positive outcomes and to maximise returns
• effective risk management is being seen as a way of enhancing shareholder value by improving performance.

Risk management is therefore the process of reducing the possibility of adverse consequences either by reducing the likelihood of an event or its impact, or taking advantage of the upside risk. It is a method of controlling risks.

Management are responsible for establishing a risk management system in an organisation.

• The process of establishing a risk management system is summarised in the following diagram:

The risk management process

The process of risk management can be explained as follows:

TARA (or SARA)

 Strategies for managing risks can be explained as TARA (or SARA): Transference (or Sharing), Avoidance, Reduction or Acceptance.

Transference

In some circumstances, risk can be transferred wholly or in part to a third party, so that if an adverse event occurs, the third party suffers all or most of the loss. A common example of risk transfer is insurance. Businesses arrange a wide range of insurance policies for protection against possible losses. This strategy is also sometimes referred to as sharing.

Risk sharing - An organisation might transfer its exposures to strategic risk by sharing the risk with a joint venture partner or franchisees.

Avoidance

An organisation might choose to avoid a risk altogether. However, since risks are unavoidable in business ventures, they can be avoided only by not investing (or withdrawing from the business area completely). The same applies to not-for-profit organisations: risk is unavoidable in the activities they undertake.

Reduction/mitigation

A third strategy is to reduce the risk, either by limiting exposure in a particular area or attempting to decrease the adverse effects should that risk actually crystallise.

Other examples of risk reduction include:

Risk minimisation.

This is where controls are implemented that may not prevent the risk occurring but will reduce its impact if it were to arise.

Risk pooling.

When risks are pooled, the risks from many different transactions of items are pooled together. Each individual transaction or item has its potential upside and its downside. For example, each transaction might make a loss or a profit by treating them all as part of the same pool. The risks tend to cancel each other out, and are lower for the pool as a whole than for each item individually.

An example of risk reduction through pooling is evident in the investment strategies of investors in equities and bonds. An investment in shares of one company could be very risky, but by pooling shares of many different companies into a single portfolio, risks can be reduced (and the risk of the portfolio as a whole can be limited to the unavoidable risks of investing in the stock market).

Reducing Financial Risk - Hedging techniques.

Risks in a situation are hedged by establishing an opposite position, so that if the situation results in a loss, the position created as a hedge will provide an offsetting gain. Hedging is used to manage exposures to financial risks, frequently using derivatives such as futures, swaps and options.

With hedging, however, it often happens that if the situation for which the hedge has been created shows a gain, there will be an offsetting loss on the hedge position.

In other words, with hedging, the hedge neutralises or reduces the risk, but:

• restricts or prevents the possibility of gains from the 'upside risk'
• as well as restricting or preventing losses from the downside risk.

Neutralising price risk with a forward contract

In some situations, it is possible to neutralise or eliminate the risk from an unfavourable movement in a price by fixing the price in advance.

For example, in negotiating a long-term contract with a contractor, the customer might try to negotiate a fixed price contract, to eliminate price risk (uncertainty about what the eventual price will be and the risk that it might be much higher than expected). The contractor, on the other hand, will try to negotiate reasonable price increases in the contract. The end result could be a contract with a fixed price as a basis but with agreed price variation clauses.

Fixed price contracts for future transactions are commonly used for the purchase or sale of one currency in exchange for another (forward exchange contracts).

Acceptance

The final strategy is to simply accept that the risk may occur and decide to deal with the consequences in that particularly situation. The strategy is appropriate normally where the adverse effect is minimal. For example, there is nearly always a risk of rain; unless the business activity cannot take place when it rains then the risk of rain occurring is not normally insured against.

Risk mapping and risk management strategies

Risk maps can provide a useful framework to determine an appropriate risk management strategy.

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Tags:	Risk management;Risk mapping;TARA;SARA