What is Risk Analysis?

Risk management is the entire walkthrough process of helping the organization manage risks or avoid them altogether. It is an in-depth study to determine the risks and uncertainties faced by the business and how these impact the objectives and outcomes of the business. Risk analysis is a procedure of risk assessment followed by the management of an organization to avoid risks that may harm the functioning and efficiency of the company.

What is the Purpose of Risk Analysis?

An organization is in the continuous process of policy enactment and action plan, which are constantly reviewed and improved based on the current circumstances to prevent any negative impact on the business profit. Likewise, the risk management team will always be ready with plans to face any unwanted occurrences. Hence, the main purpose of risk analysis is to help the organization mitigate risks and formulate necessary actions.

Uses of Risk Analysis

• Determine the probability of occurrence of risk events and calculate an estimate of its negative effects.
• The risk management team should safeguard the new project, if undertaken, against the likelihood of any negative events. These can be done by way of buying insurance, setting up security controls, etc.
• The project manager can use this analysis in determining the measures to be taken in case of failures in technology, security, equipment, etc., and identify ways in which any losses occurring due to these unforeseen events can be reduced or avoided.
• Risk analysis is also helpful in safeguarding the organizational environment by determining the risk and impact, thus making all elements within the organization feel safe.

Steps of Risk Analysis

With proper risk analysis, a detailed report of the risks involved in a business can be identified, such as

• Investigation: The first step in risk analysis is understanding where the problem lies, which can only be understood with a proper study of elements involved within the business, such as employees, staff, management, competitors, etc. Hence, conducting a proper and detailed survey is the primary step.

• Identification: Once all knowledge about the business is acquired, the next step is to probe areas where risk could be involved, such as an information system, internal control, etc. Any possibility of the least level of risks is also considered at this stage.

• Analysis of the risk: At this stage, the impact that the risk has on an organization will be considered. The possibility of the risks occurrence and the consequences to be borne, financially and objectively, are considered here.

• Developing a plan: Based on the risks to be faced and the consequences thereon, the management will develop a risk control plan, which determines the measures taken to avoid the risk or keep it minimal. An ideal plan will help the organization to avoid, reduce, or transfer the risks associated.

• Implementation: Any risk plan will only work if it has been implemented efficiently in the organization. The major goal of implementation is either to eradicate or to reduce the possibility of risks.

• Risk monitoring and control: In this case, the diligence of the management plays a crucial role as the management needs to view if the risk controls are proper and any new risks have arisen. If the management finds that the risk levels are not in control or are increasing, they may have to reassess the plan and ensure proper implementation.

Types of Risk

To perform a proper risk analysis, it is important to know the different types of risks. The two major types of risks are systematic risks and unsystematic risks.

• Systematic risk: These are more comprehensive as they could occur in the entire market segment or the entire system. These are also known as market risks as these are the kinds of risks that affect the entire market, and the impact can hardly be avoided. They cannot be entirely diversified and are also called un-diversifiable risks.
• Unsystematic Risk: Those are related to a particular industry or a specific company. These can be diversified to other investments, thus reducing the impact of the risks occurring.

Other risks are covered under these two major types. They are interest rate risk, social risk, country risk, political risk, and environmental risk covered under systematic risks and operational risk, credit risk, financial risk, operational and management risk, legal risk, and risk from competition under unsystematic risk.

Types of Risk Analysis

The risk assessment is done by the management using one of the following measures:

Qualitative Risk Analysis

In qualitative risk analysis, everything is in a defined format that includes understanding the risk, evaluating it, calculating the final impact on the organization, and determining measures to mitigate such risks.  The risk managers determine the likelihood of risk occurrence and the impact on the organization based on measurement tools. These can vary as high, medium, or low. This range is determined by questioning the perceptions of those involved in the business process, where risk probability is present, and hence these are subject-based.

Examples of tools used for qualitative analysis are SWOT analysis, game theory, etc. Based on this risk assessment, the management evaluates the security measures involved to avoid uncertainty or manage it.

Quantitative Risk Analysis

Quantitative risk assessment is mostly based on numbers, which means it measures the financial impact of a risk on the overall organization. Hence, this type considers the general overview of the organization. In quantitative analysis, a risk model is prepared with a numerical estimate of the risk impact along with the probability of its occurrence. Thus, it helps in the calculation of a potential cost.

This method analyzes the overall threat to the organization, thus giving objective data for the risk management team. Hence, it has more value in decision-making while conducting risk assessment and determining necessary measures.

One of the examples for quantitative analysis used for risk assessment by the risk managers is the Monte Carlo simulation, where random inputs are entered several times and noted down. Then the overall outcomes are used to determine the risk management measures to be reinstated by the risk management team from time to time.

Generally, the risk management team performs a qualitative analysis followed by the quantitative analysis to perform a proper risk assessment that can be used to estimate the costs of risk associated with the likelihood. By doing so, an estimate can be gathered and be used to measure if the impact will be minimal or avoidable.

What are the Benefits and Limitations of Risk Analysis?

Benefits of Risk Analysis

There are various benefits involved in risk management, as it will help the organization be well-prepared for any negative outcomes and face the impact smoothly. The benefits that a company can derive from risk analysis largely depend upon the extent to which the analysis has been done.

The more extensive the analysis, the better the risk mitigation and damage control managed by the company. Management can benefit from this in various ways, such as follows:

• A proper risk assessment helps the management recognize the risks involved, and proper risk management will help determine proper control measures to be used.
• It eases the process of risk communication amongst the employees along with proper training.
• Analyze and identify the impact that any risk would have on the company in both monetary and functional terms.
• Identify any loopholes and apply controls to monitor the security system.
• Determine and improve security policies and also strive to annihilate any weaknesses and reinforce security.
• Also, encourage communication which will help in the decision-making processes.
• Help the organization to manage and plan any costs related to these risks.

Limitations of Risk Analysis

• Risk analysis is based on estimated data, and the degree of impact cannot be precisely determined to the fullest extent.
• Also, the methods followed for risk analysis differ from each organization, and no standard method is used. Hence, it is based upon the judgment and knowledge of the risk manager.
• The level of risks is determined using the odds that may or may not occur.

Conclusion

Overall, risk analysis is a part of the risk management procedure followed by the management. It is a continuous procedure conducted from time to time so that the organization is well prepared for any unforeseen events and lessens the impact both monetarily and non-monetarily. Hence, the entire process of risk analysis and management involves identification, analysis, assessment, and solution.

Context and Applications

This topic is significant in the professional exams for both undergraduate courses & postgraduate courses and competitive exams, especially for:

• Bachelor of Commerce
• Chartered Financial Analyst
• Financial Risk Management
• Certified Financial Planner
• Chartered Accountancy

Practice Problems

Common Mistakes

• Usually, students tend to get confused between the classification of types of risks that is systematic and unsystematic risks.
• Confusion between the two may lead to an incorrect form of decision-making, which in turn may be a very hazardous suggestion.
• Another confusion among the students occurs between the terms risk assessment and risk analysis.
• Risk assessment is an entire process of identifying and assessing the risks, followed by deciding which controls are applied.
• Risk analysis is merely identifying the risks that may occur shortly and estimating the consequences of such occurrences.

Related Concepts

While studying this topic, it is important to read the following topics to get a better knowledge:

• Risk Assessment
• Risk Planning
• Incremental Value at Risk
• Risk Management
• Value at Risk (VaR)
• Risk Measurement Techniques