What is Risk Assessment: Types and Importance

Risk assessment is a crucial technique that helps in analyzing and measuring the level of risk. It has different types that are adopted based on the criticality of the risk.

To assess risk, we need to discuss the details of risk assessment in view of finance.

Table of Contents

• What is risk assessment?
• Steps
• Types
• Importance

What is Risk Assessment?

Risk assessment is the process of identifying potential hazards and analysing how it can negatively impact us. It is an evaluation of the probability that an investment may lose its value. Used across many industries financially, it determines the likelihood of asset, loan and investment loss.

It is a crucial task to determine the worth of a particular investment and the ways to mitigate risk. Through this type of assessment, one can determine the rate of return that an investor must earn so that the investment is equivalent to its potential risks. 

In case of startups, risk assessment is the most essential task since they have limited resources. In order to prevent wastage of resources, it is important to wisely use resources. This is where risk assessment comes into play. With careful assessment, proper usage of resources can be done.

Risk Assessment Steps

The following steps are followed while conducting risk assessment:

1. Identification: First of all, the potential risk is identified that may impact the process, project or the organisation. This step involves the identification of vulnerabilities, hazards and other potential sources.
2. Assessment: Once the risk has been identified, it is important to assess its probability and the potential impact. For this step, the qualitative and quantitative analysis of the data is conducted based on the risk type and data availability. 
3. Prioritization: Once the risk is assessed, it should be priotized based on the importance and potential impact. For this, a risk matrix is created which then assigns the risk score based on probability and impact.
4. Strategies development: On identifying the risk, strategies for risk mitigation should be developed. This included control implementation, risk transfer or acceptance.
5. Strategy implementation: Now, risk management strategies should be implemented and monitored for ensuring the effectiveness. This involves updating policies and procedures.
6. Review: Now, this type assessment should be evaluated and reviewed on an ongoing basis to ensure accuracy. For this purpose, regular risk assessments should be conducted.

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Types of Risk Assessment

Risk assessment includes the following types:

1. Quantitative Risk Assessment

It is a formal and systematic risk analysis approach for quantifying the risk associated with the operation of an engineering process. This is an essential tool to support the understanding of risk exposure to employees, company assets, and its reputation. It is a mathematical method that is used for evaluating numerical individual, employee and public risk level values for comparison with regulatory risk criteria. 

2. Qualitative Risk Assessment

Qualitative analysis uses subjective judgement for analysing the company’s value or prospects that are based on non-quantifiable information. These include information such as industry cycle, management expertise, research and development. In contrast with qualitative analysis, it focuses on the numbers that are found in the reports such as the balance sheet. These two techniques together examine the company’s operations and evaluate the potential as an opportunity for investing money.

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3. Preliminary Risk Assessment

This type of assessment is based on the limited information that is available during the period of facility evaluation. It is focused on the most significant risks. This is the assessment of the qualitative and quantitative risk involved in a clearly defined situation involving potential hazards. It involves analysis of technical, administrative, operational, physical and personnel variables that impact the situation.

4. Hazard Identification

This risk assessment focuses on evaluating potential hazards and risks that are associated with a specific process. The process involves defining and describing hazards by characterising the frequency, probability, severity and evaluation of adverse consequences. In most cases, it is the first step in the comprehensive assessment process.

Importance of Risk Assessment

The following reasons highlight the importance of risk assessment:

1. Mitigation of financial loss: One of the main reasons behind conducting the assessment is to mitigate any financial losses. By identifying potential risks, financial institutions can take on appropriate measures for reducing exposure to these risks and thus minimise financial losses.
2. Fulfilling Regulatory Requirements: Financial institutions conduct risk assessments to complete compliance obligations. This is an important step since otherwise it may incur financial penalties and damage the reputation.
3. Portfolio Management: Through effective assessment, financial institutions can effectively manage their portfolio. The identification of risks and mitigation, it can improve the overall performance of the portfolio. This, in turn, maximizes returns on investment.
4. Safeguarding Stakeholder Interests: Financial institutions have to protect the interest of their stakeholders, including shareholders, customers and investors. It helps in identifying and mitigating risks that may impact stakeholders to safeguard their interests.

Disadvantages of Risk Assessment Methods

In terms of disadvantages, different assessment methods have varying disadvantages.

• Qualitative method: It is subject biassed in both processes and metrics. Also, it lacks clarity in the differentiation of major risks.
• Quantitative method: This is a complex and long process that has a dependency on mathematical data. Sometimes, the data is also unavailable.
• Comprehensive method: This one is a more complex method which is difficult to implement. Also, this method requires more data for better assessment.

Conclusion 

It is an important factor that contributes significantly to financial decision-making and the process of risk management. This helps financial institutions in identifying potential risks, evaluating the impact of risks and taking appropriate measures to mitigate them. This ultimately ensures financial stability in order to protect stakeholders’ interests.