Understanding the risks that your organization faces

 

We are all used to a lot of things that naturally present within divides. For this discourse, we will just limit ourselves to two. We will talk of drainage divide. We will also talk of number-line divide. In a drainage divide, water flowing on one side of a divide empties into one body of water, while water flowing on the other side empties into another. This can be likened to the upside and the downside divide that an organisation’s risk presents.

Number-line-divide, on the other hand, that is graduated on a straight line (with a zero in the middle of the non-convergent negative and positive value extremes), serve as abstraction for real numbers. Mathematically, every point of the number line can be assumed to correspond to a real number, and every real number to a point. Point zero therefore creates a divide of the non-convergent positive and negative value extremes. Although the upside and downside risks, strictly unlike number-line extreme values could converge, the divide of the number-line nonetheless presents a simplified illustration of risk upsides and downsides.

The objectives that your organization sets out to achieve can thus be pictured as somewhere after point zero towards the positive value extreme on the number-line divide. You then have the movement toward achieving your objectives, at any point in time, anywhere on the scale. This represents the directional movement of your objectives. It is therefore important to understand the risks that cause the direction of your objectives to move upside or downside. Such understanding enables your organization to initiate strategies to maximize opportunities and to draw appetite for downsides.

We have established that risks do present with positive or negative outcomes. Most risks that your organisation faces will present with only a negative outcome. These kinds of risks are termed hazards or pure risks. Fire and accidents, generally, are in this category of risk. Hazard risk management are the oldest branch of risk management and therefore the most well understood in terms of measurability. Property and casualty underwriters provide risk transfer mechanism for organisations to mitigate hazards.

Organisations, in addition, face risks that are associated with pursuing a positive outcome. This kind of risk is considered as opportunity or speculative risks. They manifest when organisations make investments of varying types. Unlike hazards, speculative risks are not transferable through insurance, although they are largely measurable. Speculative risks fall within the realm of financial management and there are well established and advanced tools for its risk control.

Organisations also face risks that can neither be categorized as hazard nor speculation. These are termed control risks or uncertainties. The measurability of control risks present with greater difficulty when compared to hazard and speculative risks. Control risks are associated with the core processes that deliver an organisation’s products and services. Most control risks are insurable but are generally mitigated by internal control measures.

The traditional Hazard, Speculative and Control risks categorisation we discussed above are no longer best practice for financial statement disclosure and regulatory reporting. The financial professions and industries are already converging on the categorisation of these risks. There is a convergence of the International Financial Report Standard (IFRS) and risk-based solvency capital reforms on how financial instruments and risks should be categorised. We can demonstrate this linkage by matching the traditional risk categorization with the best practices.

The traditional Hazards & Control Risks equate with Operational Risk in best practice categorisation terms; Speculative or Opportunity Risks in the traditional risk classification is what best practice classifies as Market and Credit Risks respectively. Liquidity Risk classification, in best practice terms, equates with the combined effects of Hazard, Control and Opportunity risks in the traditional classification. Best practice risk categorisation permeates both financial services and non-financial services organisations alike, although the way such risks impact organisations vary. This is the reason ERM frameworks are designed to the fit of organisations.

Organisations that understand the risks that they face will manage them better. They stand to increase the chances of achieving their objectives and sustain going concern. Globally, governments and regulators are putting up measures towards helping organisations to better understand the risks that they face. Most world economies have enacted risk-based solvency capital reforms (that is converging around the Basel II/III reforms) into their national laws. This is best practice. It is the global direction. Organisations are thus more than ever before obliged to develop capacity to better understand and manage their risks.

 

Steve Nkwor MIRM (UK)

Steve Nkwor is a risk management consultant and writes from Lagos, Nigeria. He is a passionate promoter of down side zero tolerance. He holds full membership of the Institute of Risk Management of London. He is also a fellow of the Institute of Chartered Accountants of Nigeria as well as an associate of the Chartered Insurance Institute of Nigeria and can be reached on [email protected]

 

Coming up next: Proof of ERM in your organisation