Effective Risk Management in Business

Introduction

A risk is the effect of uncertainty on objectives, either positive or negative (Gorrod, 2004). Risk management is the science of identifying, assessing, and prioritizing risks. Further, this is followed by application of resources with an aim of reducing and controlling the possibility of unfortunate events or maximizing the opportunities. Risks normally result from qualms in the financial markets, failure of projects, accidents, credit risks, natural causes, and events of uncertain and unpredictable causes. There are different types of risks, and each type requires a different strategy to manage it. This research paper explores the changing landscape of risk management in pure and speculative risks (Gorrod, 2004).

Risk management tools

Realization of effective risk management is carried out through application of risk management tools (Hutto 2009). Since risk management revolves around identification, assessing, and prioritization of risks. To forecast these capabilities, some form of documentation or system software should be used. Simple risk management tools provide documentation for users. Examples of these include Capital Asset Pricing Model that determines the expected required rate of return of an asset as well as a Risk Register that provides an access to the planning and organizational risks involved in a project. Another common risk management tool is the PRA (Probabilistic Risk Assessment) which is a simple method used to get the product’s estimate probability of risks’ occurrences and their consequences (Hutto 2009).

Risk assessment

Upon identifying a possible risk, assessment of the risk should establish the probability of its occurrence and the potential negative consequences (Rejda 2011). The capacities of the latter can be either easily determined (for example, the value of a failed project) if the event is likely to happen or difficult to get if it is the likelihood of an unlikely event happening. Calculating the CRI (Composite Risk Index) determines the impact of a risk in case of the event occurrence.

It is thus evident that assessing a risk is an important stage in risk management. Once the assessment of risks is over, the risk manager lays down the measure to tone down the risks. Some of the options include avoiding the risks due to, for instance, closing a particular high-risk business area or designing a business process with adequate built in risk control measures from the start. A common measure to mitigate the risks is transferring the risk to another party (external agency), which is mostly an insurance company (Hutto, 2009).

Generally, insurance is also a favorable method to control risks (Hutto, 2009). Initially, risk management has been limited to pure risks, but the business environment is changing, so should the risk management do the same. To understand the theory of risks, insurance has to be involved as well as these notions are intertwined. In the event of pure risk, the insured individual or organization gains no profit in case the event occurs or does not occur.

In case the event happens, compensation from the victims’ insurance company brings the insured back to the original financial position. In case the event of pure risk never happens, there is no compensation to the insured; the victim also has no profits to reap from the event. Pure risks include range of accidents and liability risks to project failure risks and are fit for insurance. Other types include the speculative risks that are generally uninsurable (Rejda 2011).

Pure risks and speculative risks

Currently, risk management takes a new direction in controlling speculative and pure risks. Speculative risks are situations where there is possibility of either gain (profit) or loss. Examples of speculative risks include investing in the stock market where one may either gain or lose, and planting crops in a farm where one may successfully harvest a bountiful or harvest nothing at all in case pests and diseases invade and affect the crops (Hutto 2009).

The nature of speculative risks makes it difficult to insure against such cases. However, speculative risks carry with them intrinsic advantages to an economy in contrast to pure risks. As stated earlier, in a case of investment into stocks, a gain is likely to bring growth to an economy and to the individual. However, in case of a pure risk; a car may meet an accident or may not. If one obtains an insurance policy to insure a car against an accident, and the accident never happens, the insured does not get anything and the premium money is not refundable. Pure risks only pose threats for adverse outcomes to a country and are not desirable, speculative risks are a foundation for the economic growth of a country (Gorrod2004).

Speculative risks are gambles and are bound to result to a gain or a loss (Hutto 2009). For instance, the purchase of new equipment in an organization may result in increased productivity in case the equipment is user-friendly and easy to operate. On the other hand, the equipment may face resistance, thus causing a fall in production. The decision to venture into a new market is as well a speculative risk and is bound to result in either gain or loss. Another speculative risk is the diversification on an existing product where the market response may be positive or negative. The nature of speculative risks makes it impossible to insure for them.

Therefore, the risk management plan for speculative risks carries out a valid prefeasibility and feasibility tests. Prefeasibility tests help determine the suitability of new business opportunities. Prefeasibility studies can determine the favorability of venturing into a new identified market if a firm is in a stable financial position to borrow additional capital, in case either committing to more advertising promotes the sales product or expanding new areas of operation helps achieve success (Rejda 2011).

Conclusion

It is evident that risks are of two distinct types, pure and speculative risks (Hutto, 2009). Pure risks result in a loss, while speculative risks may cause either a loss or a gain. There are several plans to mitigate the risks which include avoiding the risks altogether, designing a business process with adequate built-in risk control measures, or transferring the risk to an insurance company. However, only the pure risks are insurable, while speculative risks are not insurable due to their nature of resulting in either a gain or a loss. Risk management tools generate metrics and track risks.

Examples include the Risk Register, which assesses the planning and organizational risks in a project. Risk management has taken a new direction to take care of the speculative risks. Prefeasibility studies have proven a success in managing speculative risks (Rejda 2011).

References

Gorrod, M. (2004). Risk Management Systems: Technology Trends (Finance and Capital Markets). Basingstoke: Palgrave Macmillan.

Hutto, J. (2009). Risk Management in Law Enforcement, Applied Research Project. Texas: Texas State University.

Rejda, G. E. (2011). Principles of risk management and insurance (11th Ed.). Boston, MA: Pearson Prentice Hall.