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The Four Types of Risk Management

The Four Types of Risk Management

In many ways, risk is the cost of doing business. Risk is incurred through every aspect of commercial business and is most clearly defined within the framework of the business contract collection. Business contracts govern all relationships and the flow of money throughout the enterprise, so the contract collection of any business provides the most comprehensive overview of the risks faced on a day-to-day basis. This includes employment, procurement and acquisition, finance, sales, and human resources.

Risk management is not about the elimination of risk. Risk can benefit businesses by creating productive opportunities, and risk management can increase efficiencies in administrative systems in a way that delivers improvements throughout the operation. The way in which risk is managed, therefore, can mean the difference between success and struggle in a commercial enterprise.

4 Types of Risk Management

The four types of risk management are quite different and cover a wide range of scenarios. They are not equally appropriate for every risk assessment, but they are an important part of initial risk management decisions to determine which technique should be used. While the choice is sometimes clear, it is important for businesses to examine risk in the context of existing systems and processes.

  1. Risk Avoidance – Avoidance of risk means withdrawing from a risk scenario or deciding not to participate.
  2. Risk Reduction – The risk reduction technique is applied to keep risk to an acceptable level and reduce the severity of loss through.
  3. Risk Transfer – Risk can be reduced or made more acceptable if it is shared.
  4. Risk Retention – When risk is agreed, accepted and accounted for in budgeting, it is retained

Everything in business involves contracts at some point. As the modern global marketplace has grown more interconnected, business contracts have become more complex. While contracts are the lifeblood of any business, they are also the business element that incurs the most risk. Risk appetite and risk tolerance are elements of the risk management program that should be kept under constant review as they fluctuate in relation to the company's financial position. The four types of risk management techniques ensure that all risk scenarios are covered by a protocol that is appropriate and effective. This relationship may be explored through the lens of the four techniques.

1.  Risk Avoidance

There are four elements to contract risk avoidance that arise after the risk associated with a contract is deemed to be too high.

  • Refusal of Proposal – If due diligence reveals the contract risk to be too high during the first stage of the contract life cycle, the company will simply decline the contract as propose.
  • Renegotiation – When risk has increased during the course of the contract life cycle, opportunities to review and renegotiate terms may be taken to introduce new conditions that avoid new risk.
  • Non-Renewal – At the end of the initial contract life cycle, the business may decline to renew the contract if the risk  is estimated as being too high.
  • Cancellation – Where circumstances cause risk to increase beyond acceptable levels during the course of the contract life cycle and outside of the agreed renewal timeframe, cancellation clauses may be enacted.

2.  Risk Reduction 

An effective contract lifecycle management system reduces the contract risk in its initial stages.

  • Contract Negotiation – When necessary, renegotiation at later contract life cycle stages can be effective in contract risk reduction, including at the renewal stage. This should always be aimed toward the mitigation of risk and the reduction of loss. 
  • Standardization – Creating a library of standardized terms, conditions and clauses is an important method of contract risk reduction. It ensures a cohesive approach by all personnel and enables teams to author contracts with the confidence of knowing that legal language is pre-approved  falls within the acceptable risk profile of the business.

3.  Risk Transfer 

The transfer or sharing of contract risk in contract management is accomplished through due diligence on third parties and subsequent outsourcing. This is an effective strategy for both manufacturing and service provision businesses where certain aspects of the operation can be contracted out to another company.

4.  Risk Retention

Every time a business signs, renegotiates, or renews a contract, there is an element of risk retention because every contract incurs risk at a some level. All active contracts represent retention of contract risk, so it is incumbent upon the business to incorporate this into risk management planning, risk assessment processes, and the regular review of the risk appetite and tolerance framework.

By building the four types of risk management into a culture of everyday best practices, commercial enterprises send a message to third parties that they are safe to deal with. This includes customers as much as suppliers. When entities and individuals know that their interests are a priority, the business benefits from repeat business and loyalty. 

Dan Townsend

No Longer with Scanmarket

Dan has been a leading executive across all areas of Contract and Compliance Management applications since 2001 in both Sales and Implementation. Dan has over 30 years management experience in a wide range of business applications such as ERP Implementations, Business Process Reengineering, and Operations Management.