The COSO Framework for Internal Control
February 12, 2025
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There is a common misconception about risk management that the goal of risk management is to completely eliminate the risk from a business. This is not really true because the elimination of risk is practically impossible. Instead, the goal of risk management is to first ensure that the organization has a clear picture of the level of risk that they are willing to undertake and then ensuring that the risk remains within those limits.
There are different approaches to risk management which result in different types of outcomes for the organization involved. Hence, the organization has to choose which approach it wants to follow. The types of approaches commonly followed have been mentioned in this article.
If you ask the management of an organization whether they want to reduce the risk in their company, the answer, most probably, will be an emphatic yes! However, it needs to be understood that risk management does not work in a silo. There is a clear and direct relationship between risk and reward. Hence, if a company wants to minimize risks, there is a high chance that they will end up minimizing the rewards as well. This is where things get tricky!
There are certain organizations that want to grow at a fast pace. Hence, by definition, they should be taking more risks so as to allow the organization to achieve faster growth. Companies need to be aware of this relationship between risk and reward. Having a policy of risk minimization and reward maximization can be inconsistent and can create negative outcomes.
The approaches commonly followed in the risk management process have been detailed below:
Derivatives are financial instruments where the underlying cash flow changes based on the occurrence of certain risky events. Derivatives help companies to contractually transfer their risk to outside parties. It is important to realize that in these cases, the risk is not completely eliminated. The company still faces counterparty risk i.e. the risk that the counterparty will not pay up in case an adverse event takes place.
Companies that have a good operational risk control process in place tend to retain risks. This is because they are confident that they will be able to manage the impact of the risk on their own. However, it is important for a company to have a strong cash flow in place so that it can wither any shocks which may arise as a result of not transferring risks.
Since catastrophic losses are less likely, the premium to be paid for transferring these risks is less. Risk-sharing can be used as an effective strategy to obtain wider coverage at a lower cost.
Once the threshold is reached, there are automatic orders in place to sell the assets and minimize the loss. The idea behind this strategy is to ensure that assets are not sold at minor valuation differences. However, when a significant drop in valuation is detected, assets must be sold in order to minimize the losses.
The bottom line is that the same risk can be handled in different ways based on the underlying policy of the firm. It is important to create a policy based on the different approaches mentioned above.
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