Identifying and Managing Risk

Risk Management is an important area which helps an establishment create value by using prevention, enablement, reduction, and enhancement projects. However, even with all the best efforts, losses do occur. Kallman (2009) explains that financing of these risks is an important component of risk management solutions. He discussed that risk control and risk financing are both important components of risk management. He discussed that the financing of risky projects could be retained or transferred. If the value of the project is low, retaining can be considered wise, however, with the rise in the value of the project, the use of the suitable combination of retention and transfer will be wiser.

As per Kallman (2009), the transfer of risks can be done by these solutions;

1. Equity: Kallman suggests the use of equity for transfer of risk for high value, speculative projects. This solution causes the transfer of variations from expected outcomes for the new shareholders. There are substantial costs of the transaction associated with this medium. Moreover, a financial intermediary is involved. The benefit is that the raised capital is not needed to be repaid, but the profits are needed to be shared with the new owners.
2. Bonds: Companies use it to finance long-term asset purchasing. It also uses a financial intermediary. The benefit of this solution is that it creates financial leverage position.
3. Securitization: This tool transfers the risk of the firm in the capital markets. However, it is very complex financing, which should be carefully used by the risk managers.
4. Derivatives: Forwards, options, futures, and swaps have included this option. These are used to hedge the cash flows and transfer the risk of loss to another party.
5. Contracts: Contracts like lease contract, subcontracting, and indemnity are used to transfers the loss to the party in the contract.
6. Incorporation: This is used to transfer the financial loss for the shareholders to the society, enabling the firm to deal with speculative projects.
7. Surety: It is used to transfer the loss of financing from the obliged to the surety.
8. Insurance: It is also a similar kind of transferring of the loss of financing from the insured to the insurer.

Kallman discusses that risk financing is only used to transfer the risk and not to decrease it. The transfer of risk can be done to smooth out the cash outflows by having to pay a stable amount. Another reason is to get the assurance of having the source for making payments in the case of any financial losses. Moreover, it can also be gained from the ancillary services associated with it. Whatever the reasons, the risk financing strategies combined with risk control strategies can provide an effective risk management strategy (Kallman, 2009).

Another study by Clifford (2017) shows the risk management techniques associated with the Models. The author discusses that managing of the model risks which includes the risks of improper managerial decisions, the risk of financial loss, the risk of the organization’s reputation, and the risk of erroneous financial statements can be very costly and challenging as well. The Model Risk Management is the field which is used to address this area of risk management. According to him, there are some fundamentals of using this framework. It includes the inclusion of the senior management and board of directors in the MRM decisions. Defining of roles and responsibilities is another major step. Other than this, the three lines of defense provides the needed mechanism for it to be effective. The model developers are responsible for the development or customization of the models from, the first line of defense. These are very well versed in the internal control and standards. The second line of defense is formed by an independent validator, which validates if the developed or customized model is aligned with the internal standards and control. They are responsible for testing and identifying the negatives of the model. The third line of defense is formed by the internal audit team which acts as the communicator between the senior management and validator and internal auditors and validator. They make sure everyone has worked as per their defined roles (Goss, 2017).

As per both authors, there is an immense need for constant analysis of the risk control and financing strategies to better align it with the changing environmental factors.

References

Goss, C. D. (2017). Managing the risks associated with models. Journal of Accountancy, 1-5.

Kallman, J. (2009). Risk Financing Transfer Tools. Risk Management, 58.