In dealing with risk there are three steps to be considered:
o Risk assessment
o Risk analysis
o Risk management
These can be considered as separate steps in the treatment of risk. The meaning of each steps is as follows:
This is concerned with the identification of risks which might occur and an identification of which particular risks might occur in the situation with which we are concerned. Once these risks have been identified then it is possible to plan strategies to manage those risks and also to undertake analysis of the possible effects of the risk.
This is the statistical quantification of the effects of the risks identified through risk assessment. The technique is based upon the probabilistic treatment of risk through the quantification of the effect of any particular risk and its consideration in terms of a probability distribution.
This is concerned with the development of strategies for dealing with risk. The development of these strategies is dependant upon the assessment of the types of risk to which the situation is susceptible and the quantification of the possible effects through analysis.
The steps in the treatment of risk can be modeled as follows:
Fig 7.1 Steps in the treatment of Risk
Risk Management Strategies
From this diagram it can clearly be seen that feedback and reiteration is a constant part of the risk management process. This is necessary in order to continually reassess the effectiveness of the risk management strategies adopted. Possible strategies are:
Avoidance would involve not becoming involved in the situation in the first place. For example a building project in an unstable country might be considered so risky that the company would not tender for the project in the first place.
This would involve taking steps to reduce the probabilities of certain unfavorable events happening in the assessment. For example for a building contract in an unstable country it might involve going into partnership with a firm from that
Protection would involve taking steps to limit the risk so in this example it might involve setting up security procedures to prevent sabotage to the building works.
This would involve contingency planning to cope with both foreseen and unforeseen situations arising during the course of the contract.
One strategy for containing risk is to transfer that risk onto another party. Possible ways of doing this include taking out insurance or sub-contracting and passing on the risk in this manner.
In all cases of strategy development the selection of an appropriate strategy depends upon a realistic assessment of the risk and a quantification of possible effects through analysis. It is to risk analysis therefore that we now turn.
Risk probability profiles
When a range of possible outcomes for an event exist then obviously the sum of the probabilities for all of the possible outcomes must equal 1 - as one of the outcomes must occur. The assignment of probabilities to each of the outcomes however enables us to construct a probability distribution showing the range of possible outcomes and their respective probabilities. Such a distribution may well be important to the analysis because merely selecting the most likely outcome might not reflect the level of risk involved.
For example, in two projects the best estimate of profitability for each of the projects is
Fig 7.2 Profitability distribution profiles
The likely profit from each of them is identical but it can be seen from the probability distributions that the risk associated with them is quite different, with one of the projects having a risk of incurring a loss (project B). Without the probability distributions therefore a firm would be indifferent as to which project was chosen but with an understanding of the distribution of risk then it can be seen that project A is the preferable project, providing always that the expected returns for the two projects are similar.
Risk analysis can be used to quantify the expected values of the return from each project but assessing the relative relationship between risk and rewards inevitably relies upon managerial judgment and a person's attitude to risk.