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What is risk management and why is it important?

Auditing 2021-12-02

Risk management activities are just as vital when it comes to personal finances. By definition, risk management is the process of understanding, analyzing and addressing potential risks to ensure objectives are achieved. Risk management is a process dedicated to identifying risks within a business and developing procedures to mitigate or eliminate those potential risks. An effective system helps maintain the safety of staff, whilst protecting business resources.

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Risk management has perhaps never been more important than it is now. The risks modern organizations face have grown more complex, fueled by the rapid pace of globalization. New risks are constantly emerging, often related to and generated by the now-pervasive use of digital technology. Climate change has been dubbed a "threat multiplier" by risk experts.

A recent external risk that manifested itself as a supply chain issue at many companies -- the coronavirus pandemic -- quickly evolved into an existential threat, affecting the health and safety of their employees, the means of doing business, the ability to interact with customers and corporate reputations.

Businesses made rapid adjustments to the threats posed by the pandemic. But, going forward they are grappling with novel risks, including how or whether to bring employees back to the office and what should be done to make their supply chains less vulnerable to crises.

 

What is Considered Risk Management?

We know based on the definition of risk management that it is the methodology used to mitigate adverse consequences that result from threats and uncertainties. Put simply, this means developing a strategy to avoid losing money when unexpected events occur.

In corporate finance, this could be a succession plan that would be put into effect when a key stakeholder of the company is no longer able to perform their duties. In personal finance, however, there are many different situations which could result in financial hardships that you will want to plan for. This planning process is risk management. The primary goal of personal risk management is to protect one’s goals, dreams, treasure and personal well-being from the “what ifs” in life.

 

Benefits of Risk Management For Businesses.

Risk management plans offer several benefits that make them a worthwhile endeavor for every business. For example, risk management plans help companies to identify the potential risks they may face. Being aware of these risks allows businesses to make plans to avoid specific risks or deal with them when they arise.

Effectively managing risks that could have a negative or positive impact on capital and earnings brings many benefits. It also presents challenges, even for companies with mature governance, risk and compliance strategies.

 

Benefits of risk management include the following:

  1. Increased awareness of risk across the organization;
  2. More confidence in organizational objectives and goals because risk is factored into strategy;
  3. Better and more efficient compliance with regulatory and internal compliance mandates because compliance is coordinated;
  4. Improved operational efficiency through more consistent application of risk processes and control;
  5. iIproved workplace safety and security for employees and customers; and
  6. A competitive differentiator in the marketplace. 

The following are some of the challenges risk management teams should expect to encounter: 

  1. Expenditures go up initially, as risk management programs can require expensive software and services.
  2. The increased emphasis on governance also requires business units to invest time and money to comply.
  3. Reaching consensus on the severity of risk and how to treat it can be a difficult and contentious exercise and sometimes lead to risk analysis paralysis.
  4. Demonstrating the value of risk management to executives without being able to give them hard numbers is difficult.

 

Risk Management Process.

There are different methods of risk management for the various types of risk; however, the process generally has three specific steps:

  1. Identify the cause and nature of the risk. To use one of our previous examples, your death would leave your family to cope with the lack of income to pay debts and living expenses.
  2. Determine how much risk you are willing to retain. This could be how much deductible you are willing to assume for an insurance policy. Or it could be your choice of a living location and the associated natural disasters of the area. Generally speaking, we all assume some sort of risk every day, it is unavoidable.
  3. Determine how to handle risk not retained.  An important risk management factor is the balancing of insurance expenditures against the risks which present the most significant negative impact on your individual personal financial plan. In theory, we could insure ourselves against almost any risk but go broke paying the premiums.

This process should be followed for any risk you want to plan for, and the list of possibilities is nearly endless. As a result, it is important to identify your priorities alongside the risks most likely to come to fruition. This means every individual’s risk management plan will be as unique as their fingerprint. It is also crucial to know that risk management is never a stagnant process, you can’t just set it and forget. You should be reviewing your risk management strategy regularly and assessing whether or not it still satisfies your current needs and objectives.

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