Risk is a fact of life for every enterprise. It refers to the possibility that an unexpected event may cause unexpected results. These results are usually undesirable and often harmful. To prevent such harm, it’s crucial to manage and control risk so that it remains at acceptable levels.
This is where enterprise risk management (ERM) enters the picture.
An organization’s ERM program aims to manage risks and mitigate their potential harm. To achieve this goal, the business can employ several risk strategies, also known as risk responses. Two common responses are risk avoidance and risk reduction. Other strategies are risk acceptance and risk transfer.
How do risk avoidance and risk reduction differ from each other? Which strategy should organizations adopt?
What Is Risk?
Risk is the probability that an unexpected situation may arise and affect the organization and its business processes, units, resources, or people. Most organizations face many types of risks. These include:
- Strategic risk: The risk that the organization may not be able to achieve its objectives
- Operational risk: The risk of loss due to disrupted business operations that might be caused by failed or faulty processes, systems, or people
- Financial risk: The possibility that a company may lose money or fail to fulfill its financial obligations, such as servicing debt
- Cybersecurity risk: The risk of a cyberattack or data breach compromising business-critical systems or data
- Compliance risk: The chance that the organization might behave in a way that violates laws, regulations, or contractual obligations
- Environmental risk: Natural disasters or climate change disrupting operations and affecting business continuity
In addition, some organizations face other kinds of risks, such as geopolitical, fraud, health and safety, and reputational risks.
What Is Enterprise Risk Management?
ERM is a holistic and continuous approach to managing risk throughout the organization. It is a disciplined method of identifying risks, preparing the company for future hazards, and enabling the achievement of strategic objectives.
An ERM program should include strategies to manage all the risks applicable to the company. It should assess what kind of future events constitute a risk by considering five key elements:
- Risk event: An event that, if realized, might cause unexpected results
- Risk factors: Events that might trigger the risk event
- Risk probability: The likelihood of the risk event happening
- Risk impact: The potential outcome of the risk event
- Risk timeframe: The time period during which the risk event might occur and result in unexpected outcomes
An effective risk management process allows the organization to consider, understand, and assess the full range of risks it faces. It examines the potential harm of each identified risk. It also determines which risk management strategy is best suited to minimize and mitigate undesirable consequences.
Two such strategies are risk avoidance and risk reduction.
What Is Risk Avoidance?
For robust ERM, risk identification and an assessment of likelihood and impact are only the preliminary steps. It’s also essential to address each specific risk to minimize the possibility of adverse consequences. There are many ways to handle different kinds of risks. One such way is risk avoidance.
Risk avoidance means completely eliminating any hazard that might harm the organization, its assets, or its stakeholders; and removing the chance that the risk might become a reality. This strategy aims to deflect as many threats as possible to avoid their costly consequences.
It is commonly assumed that risk avoidance means ignoring or failing to identify business risks and project risks. This is not true. Risk avoidance is a deliberate tactic. Like any other risk management strategy, it requires a systematic approach; and consists of the following steps:
- Identify risks
- Assess the probability and potential impact of each risk
- Calculate risk exposure by quantifying the potential losses that may result if the risk is realized
- Take steps to eliminate the risk
Examples of Risk Avoidance
An organization may decide not to make a risky investment. After analyzing the investment risks and rewards, risk managers may deem the project – say, buying a smaller company and integrating its technology into yours – too risky and not worth the potentially high reward. Thus, by choosing not to invest, they can avoid the risk of loss.
Or a company may choose to implement a proven and pre-tested technology instead of adopting a new, untested technology. The newer solution may cost less or have innovative features that could improve the organization’s performance, but could also present a higher risk of breakdowns or data breaches. The company can avoid these risks by going with the older, proven technology.
When to Use the Risk Avoidance Strategy
Risk avoidance can be the best risk management strategy when a risk could cause substantial or irreparable harm to the organization. On the other hand, when a risk isn’t likely to have a significant impact, avoidance may end up being too costly. The organization may miss out on positive opportunities, such as lower expenses or operational improvements.
To assure that the strategy is applied correctly to each risk, a thorough risk analysis and risk assessment are essential. It’s also important to determine exactly how the risk will be avoided and how that strategy could benefit the company.
The avoidance strategy may not be feasible for long-term threats. If avoidance increases costs or causes other problems, the organization should re-evaluate this response and consider different responses that could minimize the potential for loss.
What Is Risk Reduction?
While risk avoidance is about removing a risk completely, risk reduction is about lowering the risk to make its consequences less severe. The main goal is to limit the potential harm that may be caused by a risk.
The terms risk reduction and risk mitigation are frequently used interchangeably, although they are not the same. Risk mitigation refers to reducing the expected loss if a risk event happens. Generally, mitigation implies that the risk event or risky activity is still there, but the organization has created a risk mitigation plan to make it less risky.
Reducing risk is about reducing the expected loss from a risk or reducing the likelihood that the risk may occur. It includes the possibility of avoiding the risk altogether, but doesn’t require total avoidance. For example, you can mitigate the impact of a natural disaster, but you can’t reduce the likelihood of a natural disaster happening.
Examples of Risk Reduction
An organization may implement a quality management system (QMS) to assure that its goods and services meet pre-defined specifications or quality standards. This risk reduction strategy aims to lower the risk that output quality will be poor or undesirable to stakeholders.
Another example is implementing a digital platform such as ZenRisk to track regulatory requirements, implement the required controls to maintain compliance, and reduce the risks of non-compliance.
Other examples of risk reduction include:
- Changing a process to reduce health and safety-related risks
- Changing the organizational culture to reduce the risk of high employee turnover
- Performing due diligence on third parties to assure that the party doesn’t pose excessive security or compliance risks
When to Use the Risk Reduction Strategy
If a risk cannot be entirely avoided, reduction may be the most suitable option. For example, it’s almost impossible to avoid the risk of a cyberattack entirely. Organizations can, however, reduce the likelihood of a security event by implementing antivirus and antimalware software, firewalls, endpoint detection and response (EDR), and other security solutions.
Risk Avoidance vs. Risk Reduction
Risk avoidance is the only risk management strategy where the goal is to eliminate all probability of a risk from happening. It is usually adopted when the risk can potentially inflict catastrophic damage or when the costs of risk mitigation are higher than the benefits.
On the other hand, risk reduction requires taking specific actions to minimize the likelihood of the possible risk. It may involve implementing controls, policies, or procedures to reduce the chances of harm and make the risk less severe and more manageable. The risk does now, however, disappear completely; the organization has to find a way to “live” with it.
How Risk Avoidance and Risk Reduction Are Part of a Risk Management Plan
Whether a firm adopts a risk avoidance or risk reduction strategy depends on the type of risk in question and its potential impact on the company’s finances, processes, security, workforce, and customers.
To choose the right strategy, it’s vital to identify the risks that affect (or may affect) the organization. It’s also critical to quantify each risk to assess its potential impact.
In general, the success of both strategies depends on:
- Creating and communicating policies
- Implementing proper procedures
- Leveraging the right technology to support the strategy
- Training employees to assure that they behave in risk-appropriate ways
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