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Risk assessment techniques - Coggle Diagram
Risk assessment techniques
Qualatative risk assessment
Involves a significant degree of judgement
Similar techniques to those used for risk identification are often used, including expert judgement, focus groups and surveys
The dominant qualatiative technique is to estimate probability and impact using an ordinal scale
Ordinal scales may be of any length but the most common are scales of three and five
Some organisations may dispense with numbers altogether and just use words to describe the level of probability and impact - different terms may be used, such as almost certain, severe or extreme for higher values or minor, insignificant and negligible for lower ones
The exact terms used are not important as long as their order of magnitude is clear
It is common to provide definitions for these terms to help improve the accuracy and consistency of risk assessment activities across an organisation
Organisations may separate financial and non financial impacts, such as reputation or customer satisfaction
For further detail, two levels of assessment may be performed, one for inherent risk and another for residual risk. This is to show the potential exposure to the risk, should controls not be in place and the current effectiveness, in terms of reduced probability and impact, of the controls that have been applied to the risk
A final extension combines probability and impact to arrive at an exposure score. Usually the ordinal values are multiples together to arrive at an order of magnitude for exposure
Quantitative risk assessment
Quantitative assessment applies a standard of measurement to probability and impact to allow a more precise and objective analysis of risk
With quantitative methods, it is possible to determine how much bigger a given probability or impact value is than another
Quantitative risk assessment uses the principles of statistical analysis, it is concerned with building and analysing complex distributions for probability and impact, combining these distributions to arrive at an objective assessment of risk exposure
Quanatitative risk assessment is superior to qualitative approaches, it is precise in mathematical terms and does not rely on subjective judgement - instead quantitative risk assessment uses historical data
In practice, qualitative risk assessment is problematic - data is not always available, especially for very low probability risk events
In addition, there is no guarantee that what has happened in the past will happen in the same way in the future, especially in complex and changing risk environments. The effect of global warming is a good example of this - extreme weather events appear to be on the increase, meaning that historical weather data is much less effective at predicting the future than it should be
Quantitative risk assessment is used most in the financial services sector for assessing financial risks such as the market and credit risk where data is plentiful or for the risks insured by insurance companies
Hybrid approaches - stress testing and scenario analysis
Hybrid approches combine elements of quantitative and qualitative risk assessment - the aim is to provide a relatively consistent and objective method for assessing risk
Stress testing
Stress testing involves assessing the impact that extreme movements in key financial variables may have on an organisation, either in isolation or together
Common variables include
A fall in income
Rising inflation
Rising or falling interest rates
Fluctuations in cash flows
A sudden increase in costs
Stress tests are often performed by the finance function to assess the effect that extreme movements in financial and economic variables may have on an organisation's income statement or balance sheet
An extension of standard stress testing is the reverse stress test which establishes the point at which an organisation's objectives are no longer achievable.
Reverse stress testing is a useful tool for corporate financial resiliency planning. There are two approaches to reverse stress testing
Define a series of events, which may happen independently or as a sequence, which will cause the business plan to fail then measure the implications on the business plan for each of the identified events
Start with the income statement and balance sheet of an organisation and investigate each line item. Identify the factors that would affect that line item to such a degree that the business plan fails or the organisation becomes insolvent
Stress testing is a good way to assess the financial strength of an organisation, especially when faced with extreme events.
It can help an organisation to prepare for extreme events should they occur, helping to reduce the chance of significant financial distress or bankruptcy
Scenario analysis
Scenario analysis was first used as a strategic planning tool to help organisations identify potential futures and to prepare for them.
In a risk management context, a scenario is essentially a story, an outline, a description or model of a possible sequence of risk events
Relevant experts and managers determine plausible but extreme future scenarios and then assess the impact on an organisation should the scenario manifest itself
There are two principal types of scenario: single variable scenarios and multi-variable or multi-variant scenarios
Single variable scenarios focus on a specific event or occurrenc, the assessment looks at both the possible frequency of occurrence and impact from that single event
Multi-variable scenarios are more complex and examine the occurrence of multiple inter-related events which may occur at the same time or as a chain of linked events
Scenario analysis is time consuming to do properly and may involve a number of functional specialists and managers but the benefits are considerable - scenario analysis can help organisations to anticipate and prepare for extreme scenarios
It is especially well suited to testing business continuity plans and for estimating the maximum level of loss which can help determine the level of insurance cover
More accurate probability and impact values for extreme events may also be determined allowing an organisation to rank scenarios in order of significance - this allows scarce management and control resources to be targeted at the scenarios that an organisation has a higher exposure to