Mastering Risk Assessment

Rejecting risk

is the

head-in-the-sand approach

Wednesday 12 April 20231 QHSE office [ www.qhseoffice.com ]

INTRODUCTION

The recent news headlines related to subprime mortgage crisis, rogue traders, and corporate fraud have highlighted that despite investment in risk assessment and risk management disciplines, significant risk failures persist. While isolated incidents of one time governance failures are bound to occur, long term systemic failures are more than just an isolated anomaly.

The failures may be the result of a clutter of risk information caused by many risk assessments from many perspectives. The process of organizing these risk assessments to provide organizations with a more holistic view of enterprise risk is fundamental to mastering risk assessments. This whitepaper explores approaches to risk assessment, offers some best practices for conducting risk assessments and provides practical guidance on mastering this business process.


RISK ASSESSMENTSTHE BASICS

Risk assessments fall into the overall discipline of risk management. Risk is defined as the uncertainty of an event occurring that could have an impact on the achievement of objectives. The definition of risk assessment then follows as the identification, evaluation, and estimation of the levels of risks involved in a situation, their comparison against benchmarks or standards, and determination of an acceptable level of risk. A risk assessment should answer the following five questions:

1. What can go wrong?

2. How can it go wrong?

3. What is the potential harm?

4. What can be done about it?

5. How can we stop it from happening again?


THE EMERGENCE OF RISK: BASED APPROACHES

To minimize the confusion of varying risk information, risks assessment efforts need to converge. Risk convergence, the ability to look across the organization and to understand all risk information from a single perspective, is essential to be able to understand and organize the different types of risk information in order to promote the understanding and analysis that will add value to the organization.

The following best practice approaches will help an organization master risk assessment and minimize disjointed risk information:

1. Use a risk-focused approach

2. Adopt a common categorization of risk types

3. Parse the risk jumble

4. Perform scenario analysis

5. Use a risk table

6. Monitor risks

7. Increase self assessment

8. Achieve risk convergence


USE A RISK-FOCUSED APPROACH

Risk-based approaches can be described as those that provide a ratio of at least 2:1 of risks to controls and generally have the opposite bias; producing significant amounts of information about risk events, their type, frequency, level, impact and root cause. With the capture of proper risk information, risk-based approaches provide management a better perspective on significance and likelihood of risk events and enable management to prioritize the materiality of mitigating controls.

One of the major reasons for the ineffective execution of risk assessments is the significant focus on controls. The control-based approach is used to identify and assess controls, or more specifically the risk of missing or broken controls; the risk-based approach is used to identify and assess risk events, or risks that could impact the achievement of business objectives. Risk assessments are much more effective when using a true risk-based approach.


A COMMON CATEGORIZATION OF RISK TYPES

To assist in the discipline of risk assessment, it is important to have a common taxonomy and categorization of risk types.

The risk management community has provided numerous risk models to categorize risks into types for reporting and analysis purposes.

With a library of common sets of risk categories, risk assessment practitioners are better able to identify the organization's risks and can pull together risk information in a concise profile that helps users understand and monitor identified exposures.



ENVIRONMETAL RISKS

Business continuity

Business market environment

Environmental

Liability lawsuits

Natural disasters/weather

Pandemic

Physical damage

Political risk

Regulatory/legislative

Terrorism

FINANCIAL RISKS

Capital availability

Credit counterparty

Financial market risk

Inflation

Interest rates

Liquidity



SUPPLY RISKS

Commodity prices

Supply chain

MANAGEMENT RISKS

Corporate governance

Data security

Employee health and safety

Intellectual property

Labor disputes

Labor skills shortage

Managing complexity

Outsourcing problems

Project management

Technology failure


PARSE THE RISK JUMBLE

Risk information must be organized to be understood and managed. In the jumble of risk information that is currently being gathered, some of the information is about controls or more accurately missing or broken controls, some of it is about risk events (the events the controls were designed to mitigate) and some of the information describes the primary or secondary consequences of the risk events if they occur. The result is a mass of information that is described as risk, but it is not all risk.


PARSE THE RISK JUMBLE


SCENARIO ANALYSIS

The discipline of scenario analysis is critical to effective risk assessments because it forces one to ask, “What could go wrong in the future?” Scenario analysis is the process of analyzing a number of possible future events and focuses attention on all possible outcomes of an event occurring and the associated impacts. Proper scenario analysis improves decision-making by allowing management to more completely consider various outcomes and their implications to an organization.

For example, in looking at the scenario of fraudulent trades occurring, the following questions need to be evaluated:


SCENARIO ANALYSIS

1. Where does trading activity take place?

2. What kinds of trading takes place?

3. What are all the ways unauthorized trading could take place?

4. How up to date is our information?

5. Have we involved everyone with relevant knowledge in risk identification?

6. Have we involved everyone with relevant knowledge in control assessment?


SCENARIO ANALYSIS

7. What would tell us if, in fact, unauthorized trades are occurring?

8. How often do we formally analyze this scenario?

9. What issues have we identified in the past?

10. What losses have our industry competitors experienced?

11. How could trades be hidden?


USE A RISK TABLE

Risks and the corresponding risk assessments can be evaluated using either a quantitative or a qualitative approach. Quantitative assessments use actual dollar amounts to provide an financially-based risk value. Qualitative assessments use scoring methods and the experience of employees and consultants to arrive at a risk score. Since determining an actual dollar value of risk is often times a very resource intensive activity, the qualitative risk assessment approach is used as a best practice by most risk assessment groups. Although termed a qualitative approach, this method typically involves assigning some numerical value that can be used to stack rank or come up with some relative ratings on the assessment of risks.


USE A RISK TABLE


USE A RISK TABLE

Wednesday 12 April 202316

Once the risk assessments are scored using a risk table, they should be sorted from highest to lowest. This allows organizations to address the highest risks first. Once identified, there are essentially four ways to deal with each risk:

Reject the risk: Rejecting risk is the head-in-the-sand approach. Some managers tend to ignore difficult challenges with the hope that they will simply disappear. This approach will rarely result in a successful defense against the risk event occurring.

Accept the risk: A common action to take is to accept the stated risk. For example, if the controls necessary to eliminate or mitigate key vulnerabilities are a greater financial burden to an organization than the actual risk impact, then it’s probably a good idea to use the budget dollars in other areas.

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USE A RISK TABLE


Transfer the risk: An alternative to accepting a higher than reasonable risk when the cost of controls is too high is to purchase insurance to lower the business impact of an incident. This is a common risk management step.

Mitigate the risk: Risk mitigation typically focuses on managing the areas where the organization is most vulnerable. Risk mitigation involves the identification and management of risk mitigating controls.


MONITOR RISKS


A best practice in mastering risk assessments is to establish standard metrics for the consequences and outcomes that will drive business decisions. Common metrics are classified as key performance indicators (KPI) and key risk indicators (KRI).

A KPI is part of a measurable objective and helps an organization measure progress towards goals, especially toward difficult to quantify knowledge-based processes. KPI’s are made up of a direction, benchmark, target and time frame.


MONITOR RISKS


A KRI measures how risky an activity is. It differs from a KPI in that the KPI is meant as a measure of how well something is being done. A KRI is an indicator of the possibility of a future adverse impact. The idea behind the KRI is to provide a set of agreed indicators, which can range from the simple, such as staff turnover, to the more sophisticated, such as the a complex calculation for measuring operational performance. The behavior of KRIs should signal how well or how badly a firm is managing potentially costly operational hazards such as fraud, legal risk, technology failure and trade settlement errors.


INCREASE SELF ASSESSMENT


Using risk self assessment drives the responsibility and accountability of risk management to process owners by reinforcing their responsibility and accountability for the risk areas that they own. Companies embracing risk self-assessment often view it as a cost-effective technique for establishing touch points with the right people, enabling management to communicate as well as educate. An effective risk self-assessment program reports risk assertions from process owners upward in the organization and identifies matters requiring follow-up and possible disclosure.


ACHIEVE RISK CONVERGENCE


Risk convergence is the integration of discrete risk assessment information into a unified framework in order to dramatically:

Streamline processes

Increase assurance reliability

Increase information quantity/quality

Decrease operational cost

Contribute directly to better business performance


ACHIEVE RISK CONVERGENCE


Risk-based approaches to management hold significant promise. If risks are understood in terms of cause/effect relationships, governance failures and losses should be prevented. If variance in expected business or process performance is viewed from a risk perspective as unmanaged risks, then business performance should improve or at least become less volatile. Risk assessment is the foundation of risk management. Organizing the information produced through risk assessment will allow risk convergence to fulfill its potential.


THOUGHTS


To minimize the confusion of varying risk information, risk assessment efforts need to converge.

Risk information can be categorized as root cause, risk event, consequence and downstream effect.

Effective risk assessments force one to ask, “What could go wrong in the future?”

Rejecting risk is the head-in-the-sand approach.

Establish standards for the consequences.

“QHSE office” provide a common point of entry for audit, risk management and compliance owners.


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Mastering Risk Assessment