Risk: Definition and Types
DEFINITION
Risk, in a general sense, refers to the potential for harm or loss, often associated with uncertainty or the probability of adverse events. Risks, in the context of financial management, can be broadly defined as uncertainties or events that have the potential to impact the achievement of organizational objectives. These uncertainties can manifest in various forms such as biological, environmental, psychological, natural, or technical.
✏️ Definition of risk according to different organizations
1. ISO Guide 73, ISO 31000: Risk is the effect of uncertainty on objectives, whether positive or negative.
2. Institute of Risk Management: Risk is the combination of the probability of an event and its consequence.
3. Orange book from Her Majesty’s Treasury: Risk is the uncertainty of outcome, within range of exposure, arising from a combination of the impact and the probability of a potential event.
4. Institute of Internal Auditors: Risk is the uncertainty of an event occurring that could have an impact on the achievement of the objectives.
TYPES OF RISK
Risk can be broadly categorized into two main types:
A. SYSTEMATIC RISK
Systematic risk, also known as market risk, refers to the inherent risks associated with the overall market or the entire economy. These are factors that affect all assets in a market, and they are beyond the control of individual companies or investors. For example: Economic downturns, interest rate fluctuations, inflationary pressures, political instability, natural disasters, etc.
Financial Risks
Financial risks involve potential financial losses that organizations may face due to market volatility, currency fluctuations, interest rate changes, credit defaults, and liquidity constraints. These risks often emerge from broader economic conditions, interest rate changes, and market fluctuations.
Compliance Risks
Compliance risks emerge from the potential failure to adhere to various legal, regulatory, and ethical requirements imposed by government authorities, industry bodies, or other relevant entities. Non-compliance with these rules can lead to legal consequences, financial penalties, damage to reputation, and operational disruptions.
Environmental and Sustainability Risks
Environmental and sustainability risks emerge from changes in environmental regulations, emission standards, resource scarcity, and other sustainability requirements that may impact the operations, costs, and competitiveness of a company.
Supply Chain Risks
Supply chain risks include disruptions in the supply chain (the flow of goods and services) due to natural disasters, global economic conditions, geopolitical events, or economic downturns.
Political and Regulatory Risks
Political and regulatory risks emerge from changes in government policies, political instability, geopolitical tensions, and evolving regulatory frameworks. These factors can impact financial performance and introduce uncertainties for organizations.
B. UNSYSTEMATIC RISK
Unsystematic risk, also known as asset-specific risk, is a risk that is unique to a specific company or industry. It can be mitigated through diversification because it arises from factors that are specific to a particular investment.
Opportunity Risks
Opportunity risks refer to the potential loss or unfavourable outcomes associated with choosing one option over another. These involve the potential risks associated with missed opportunities or failure to capitalize on favourable circumstances.
Operational Risks
Operational risks refer to the potential challenges and uncertainties associated with the day-to-day operations of an organization. These risks can emerge from inefficiencies in internal procedures, human errors, technology failures, disruptions in the supply chain, fraud, and other operational shortcomings within an organization.
Strategic Risks
Strategic risks refer to the uncertainties associated with the strategic decisions and directions taken by an organization. These may include market shifts, competitive pressures, changes in consumer behaviour, and geopolitical influences.
Reputational Risks
Reputational risks involve potential damage to an organization's reputation, brand image, or public perception. Negative events such as scandals, ethical lapses, or public relations crises can significantly impact how stakeholders, including customers, investors, and the public, perceive the organization.
Cybersecurity Risks
With the increasing reliance on digital technologies, cybersecurity risks have become a critical concern. These risks encompass the potential threats to an organization's information systems, data breaches, hacking attempts, and other cyber threats.
Control Risks
Control risks are often specific to internal processes and governance within a company. Control risks relate to the potential failure or weaknesses in internal controls that organizations have in place to manage and mitigate various risks. Inadequate internal controls can lead to errors, fraud, and financial misstatements.
VG: it is the possible statement in an assertion about a transaction, account, balance, or disclosure that could be material either individually or when aggregated with other statements due to failures in the controls used by a business. When there is significant control, failures of business are more likely to experience documented asset losses, which means that its financial statement may reveal a profit when there is a loss.
Hazard Risks
Hazard risks encompass the potential dangers associated with physical or environmental factors that could harm assets, employees, or operations. These risks may include natural disasters such as earthquakes, floods, or fires, as well as other hazards like accidents or equipment failures.
VG: It poses a level of threat to life, health, property, or the environment. Most hazards are dormant or potential with only a theoretical risk of harm. Once a hazard becomes active, it can create an emergency.