Every business owner knows that dealing with risk is par for the course of running an enterprise. From fluctuating market conditions and operational mishaps to regulatory changes and advances in technology, risk is firmly embedded in a business’ life.
Knowing how to manage these risks effectively is without doubt a necessity for achieving long-term stability and success. For specific risks, there are different types of risk management techniques, but broadly, there are 3 types of risk management strategies – Financial, operational, and strategic risk management.
In this blog, we’ll take a look into each of these types of risk management strategies in detail.
Overview of 3 Types of Risk Management
Risk is an inevitable part of doing business, and while it cannot be completely eliminated, it can certainly be managed. Broadly, there are three types of risk management strategies:
1. Risk Avoidance
As the name implies, risk avoidance is a risk management strategy that focuses on completely avoiding risk. You know that something is risky, and you take active steps to avoid it. Here are a couple of common examples to understand this – We all know that smoking can cause irreparable damage to the lungs and exposes the body to a variety of diseases. So, to avoid these health risks, many people choose not to smoke in the first place. They are avoiding this risk. Similarly, a business might decide not to launch a product in a new market because of excessive and established competition.
2. Risk Loss Prevention and Reduction
Risk loss prevention and reduction is a risk management strategy that focuses on minimising the chances of a risk happening, that is, preventing risk, as well as minimising the impact if that risky situation does come to pass, that is, reducing risk. Let’s use another health example. With health insurance policies, you also get free preventative health check-ups. Through them, you can detect any health problems early and prevent serious illnesses from developing.
Now let’s say there’s a business that focuses on heavy production. To prevent risks, it can conduct regular maintenance of equipment and factories. But if something happens, like a factory fire, the business should have plans in place to reduce the losses like investing in safety equipment, sprinklers, and alarms.
3. Risk Retention
When businesses acknowledge and accept that some types of risks are inevitable or manageable, they adopt a strategy known as risk retention. Businesses don’t avoid risk or transfer it, they simply choose to retain it because generally, the potential costs of mitigating the risk outweigh the actual risk itself. They do a cost-benefit analysis and account for the risk in budgeting. For example, a big retail company might decide to retain the risk of losses caused by shoplifters instead of investing in an expensive, high-tech security system.
By doing this the company is acknowledging that there is a shoplifting risk, but the overall financial impact of these small, occasional losses is minor compared to the cost of an expensive security system. This risk management strategy is adopted when the risks are small and predictable, and don’t cause a lot of damage.
If a business finds itself unprepared for the many uncertainties that surround it, it can be exposed to financial losses, damage to reputation, or even a complete business failure. That’s why the importance of risk management cannot be overstated.
3 Types of Risks in Risk Management
Other than the above 3 types of risk management strategies, companies can also adopt a risk transfer strategy where the risk to the business is transferred to a third party, like by buying insurance. A business can also share risk, where the risk is divided between multiple parties through joint ventures or partnerships.
Now that you have a brief overview of the different ways a business can manage risk, let’s take a look at the types of risks that can affect them. We’ll broadly categorise them into three types:
- Financial Risks
- Operational Risks
- Strategic Risks
Let’s take a look at each of these risks and how they can be managed.
Financial Risk Management
Financial Risks
Any risks that can harm a business’s finances are called financial risks. This can mean the possibility of losing money on an investment, transactions, contracts, new ventures, and so on. Basically, any danger that can lead to a loss of capital can be called a financial risk. There are many causes of financial risks. They can arise from a variety of factors such as company liquidity concerns, market volatility, changes in interest rates, and fluctuations in currency exchange rates. Have a look at some types of financial risks:
Market Risk
This type of risk stems from changing market conditions such as changes in the stock market or commodity prices.
Credit Risk
This is the possibility that a borrower might fail to repay the interest or principal amount on a loan. Credit Risk also known as default risk.
Liquidity Risk
Every business needs cash for its day-to-day operations, supply payments, meeting payroll, covering rent, and other short-term obligations. Liquidity risk is the risk of not being able to meet short-term financial obligations due to a shortage of cash or the inability to convert assets into cash quickly without loss in value.
Interest Rate Risk
The value of a business’s assets might go down due to the rising interest rates. For example, if a company has a lot of variable-rate debt the interest payments on this debt will increase as interest rates rise.
What Is Financial Risk Management and Why Is It Important?
Financial risk management is the process of identifying all these financial risks posed to a company and taking steps to reduce their impact on the company’s profitability. The world of finance is dynamic, so a company must always be prepared to withstand economic shocks.
For example, a company can mitigate the impact of fluctuating interest rates by locking in fixed interest rates for borrowing. Similarly, a business should always maintain an adequate level of liquidity to manage its short-term obligations without any problems to avoid liquidity risks. To reduce the threat posed by market risks, a business can diversify its investment portfolios and constantly monitor trends.
Having a solid financial risk management strategy in place can also help businesses thrive in competitive markets and also increase investors’ confidence.
Operational Risk Management
Operational Risks
These types of risk come from how a business operates itself, so there are many sources of operational risks. They can come from people, like a company may not have enough employees or enough qualified workers. They can arise from processes, such as unsafe manufacturing processes. Operational risks can also be caused by systems, that is, the failure of the technical part of a business, and finally, they can sometimes arise due to external events such as natural disasters.
These types of risks can disrupt the entire working of a business, which can lead to financial and reputational loss. Take a look at some types of operational risks:
Tech Failures
Computers, software, machines, and other IT system-related breakdowns can cause operational delays or even expose businesses to cyberattacks.
Human Errors
Employees can make mistakes due to not being experienced, trained, or by simply being humans.
Internal and External Frauds
In some cases, employees try to steal from the company and misuse its resources. Businesses can also be targets of fraud by external players through cyberattacks.
Process Executions
Every business has its own processes. If the management cannot lay out efficient or safe processes, it can lead to many problems like operational disruptions, increased costs, safety hazards for employees, quality issues, and compliance failures.
Disruptions in Production or Supply
A business that focuses on the production of goods depends heavily on supplies. Unreliable suppliers or machinery can cause delays and financial loss.
What Is Operational Risk Management and Why Is It Important?
Through operational risk management, businesses focus on creating strategies that reduce the chances of failures that can happen in their day-to-day operations. They identify the sources of these risks, analyse how they can impact them, and develop ways to avoid, reduce, or retain these risks. For example, a goods production-focused business can avoid supply chain risks by having contracts with multiple suppliers. A more tech-based business can give their employees through training to reduce human errors. A business can also invest in cyber security systems to keep itself safe from cyber attacks.
With proper operational risk management, businesses can increase their productivity, reduce the chances of technical failures, make production more reliable, create a safe environment for employees, and maintain high standards to deliver consistent results.
Strategic Risk Management
Strategic Risks
Every business has long-term goals. To achieve these goals they have to consider a variety of strategic risks that can have an impact on their success. These strategic risks arise from external and internal events – factors like business environment, competition, market dynamics, policy changes, wars, pandemics, new innovations, changes in customer preferences, or other factors that can affect a company’s ability to achieve its strategic goals. Here are some types of strategic risks:
Political Risk
Changes in government and policies can have an impact on how a business operates.
Innovation Risk
Those who don’t keep up with new technology get left behind. Failure to innovate can lead to inefficient production and loss of competitive edge.
Competitive Risk
Not keeping up with the competition in terms of prices, services, goods, and technology can reduce the market cap of a business.
Regulatory Risk
New regulations can change the way a business operates. For example, new safety regulations can force a business to invest in better equipment and safety training, environmental regulations can change how a company manages waste, emissions, or energy use.
Market Entry Risk
To expand, a business must thoroughly research new markets. Failure to do so can cause massive financial losses.
Reputational Risk
A business must always maintain the trust of its customers and investors. Poor decision-making from upper management can lead to reputational damage, reduced market share, and lower profits.
Strategic Risk Management and Its Importance
Strategic risk management allows companies to prepare for these strategic risks that pose a danger to their long-term goals. It creates long-term stability for a company because decisions taken by leaders take sustainability into account. Being prepared for strategic risks allows companies to be more responsive to changes in markt, technology, and regulations. Companies can also capitalise on new opportunities and maintain their competitive edge.
Conclusion
There are broadly three types of risks in risk management – financial risks, operational risks, and strategic risks. Financial risks threaten a company’s financial stability and profitability due to market conditions, credit defaults, and liquidity issues. Operational risks are related to the internal components of a business like employees, processes, and systems. Strategic risks pose a danger to a business’s long-term goals and are associated with factors like changes in policies, regulations, innovations, and reputation.
For a business to succeed, the importance of risk management cannot be overstated. Generally, there are five ways a business can manage risks – it can either avoid, retain, reduce, transfer, or share risk. All risk management strategies come from these basic methods and a mix of these approaches is suited to tackle different types of risks. An effective risk management strategy can help businesses protect themselves from threats, gain the trust of investors and customers, improve their efficiency, and succeed in the long term.
