1

INTRODUCTION TO RISK
LEARNING OUTCOMES
After going through the chapter student shall be able to understand
 The Concept of Risk
 Risk and Uncertainty : Distinction
 Classification of Risks
 Dynamic Nature of Risks
 Types of Risk (illustrative list)
• Strategic and Operational Risks
• Business Risk
• Financial Risk
• Information Risk
• Liquidity Risk

1. INTRODUCTION & DEFINITIONS

Risk derives from the early Italian word “risco” which means danger or “risicare,” which means “to
dare” or French word “risqué”. Risk is a choice rather than a fate. The actions companies dare to
take are central to our definition of risk. Risk and reward are two sides of the same coin. Risk
leaders choose their risks well. They look at external and internal risks in broad context. They
integrate decisions with corporate strategy, and strike a healthy balance between risk
management as an opportunity and a protection shield.

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A business event if it occurs; can have a positive or negative impact on business’s objectives.
Generally when we discuss risks we fall into the trap of thinking that risks have inherently negative
dimension. However, one should be open to those risks that create positive opportunities; you can
make your business faster, better and more profitable. Let us look at a example here say on
account of non-compliance with environmental laws few old suppliers of a Corporate entity were
restricted from supplying materials to the Corporate entity at preferred rates. This posed a
challenge to the corporate entity as they have to find new suppliers who would be compliant with
environment laws and also perhaps the new rates would be significantly higher than the preferred
rates of the old suppliers. The Corporate entity undertakes a detailed supplier discovery exercise
and realises that the new suppliers are willing to supply materials at rates that are lower than the
preferred rates (agreed with their old suppliers), thus a potential challenge or threat has been
converted into an opportunity to reduce the Corporate entity’s procurement spend. Think of the
adage – “Accept the inevitable and turn it to your advantage.” That is what you do when you take
business risks to create opportunities.
Risk arises on account of uncertainty of occurrence and unknown consequences if the risk event
were to occur. Uncertainty is unpredictable, and has an uncontrollable outcome; taking risks
means taking steps or business actions inspite of uncertainty. The degree of uncertainty or
likelihood of occurrence and impact of the risk outcome combined together forms the magnitude of
the risk. Therefore, measurement of uncertainty and unknown consequences lie at the heart of risk
management. Refer Table 1 for various important definitions of risk.
1.1 ICAI Guide on Risk Based Internal Auditing
Meaning of Risk
Organisations exist for a purpose. Whereas the private sector strives to enhance shareholder
value, the Government and Not for Profit organizations have a main purpose of delivering service
or other benefits in public interest. Achievement of organisational objectives is clouded by
uncertainties that both poses threats to and offers opportunity for increasing success. Businesses
operate in dynamic environment where change is a constant. Risks arise on account of internal or
external factors and circumstances. These circumstances need to be assessed with reference to
the organisation's objective.
In a larger sense, risks are those uncertainties of outcome, whether an opportunity or threat,
arising out of actions and events. While looking at them narrowly, risks are those uncertainties
which impede the achievement of the objective.
Business Risk
Business risks impede the achievement of the organisation's goals and objectives.
All entities exist to provide recognizable benefits for their stakeholders or, in other words to create
value for them. Value is created if a stakeholder gets more of something he finds important. Value
is created or destroyed by (management) decisions. Decisions entail the recognition of risk and

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opportunity and require that management considers information about the internal and external
environment, deploys scarce resources and recalibrates activities to changing circumstances.
Today’s business is constantly changing. It is unpredictable, volatile and seems to become more
complex every day. By its very nature, it is fraught with risk. Organizations thus face uncertainty,
and they are not able to precisely determine likelihood and impact of potential events.
Risk Management enables management to deal with risks by reducing their likelihood or downside
impact. It aims to protect the value already created by the organization, but also its future
opportunities.
Historically, businesses have viewed risk as an evil that should be minimized or mitigated. In
recent years, increased regulatory requirements have forced businesses to contribute significant
resources to address risk, and other stakeholders in turn have begun to scrutinize whether
businesses have the right risk mitigation controls in place. To achieve sustainable success
business entity has to continuously identify, assess, measure and manage risks so as to achieve
its business objectives and fulfil promises made to stakeholders. Absence of risk management
means inviting “Frog in the Well Syndrome”. Frog in the well is a Chinese idiom which means a
person who is a narrow or close minded person. A frog living in the well believes that is the only
world and nothing beyond it exists.
A fast evolving business scenario, climate change, uncertainty arising from global events
especially protectionist regimes, innovation, start-up disruption, robotics and automation,
competition and volatility of prices, aggressive organisational cultures, heavy regulatory
interventions, creates stress and complexity in managing life and businesses. Black swan events,
climate crisis and high profile corporate failures in the world have brought risk into the agenda of
governments, regulators, boards and societies. Terrorist acts, extreme weather events and the
global financial crisis represent the extreme risks that are facing society, commerce and
businesses. These extreme risks exist in addition to the daily, somewhat mundane risks.
The Oxford English Dictionary definition of risk is: ‘a chance or possibility of danger, loss, injury or
other adverse consequences’ and the definition of at risk is ‘exposed to danger’. In this context,
risk is used to signify negative consequences. However, taking a risk can also result in a positive
outcome. There is a possibility that risk is related to uncertainty of outcome.
Take the example of traveling by an aeroplane. For most people, traveling by an aeroplane is an
opportunity to save time and gain the related benefits. However, there are uncertainties in traveling
by an aeroplane that are related to accidents, delays and higher costs. So there are obvious
negative outcomes that can occur.
The outcome of Risk is the potential of gaining or losing something of tangible value. The
consequence of risk outcomes shall be on health, social status, emotional well-being, financial
wealth or reputation/ goodwill can be gained or lost when taking risk resulting from a given action
or inaction, foreseen or unforeseen. In business and monetary terms, the value of risk outcomes
shall be on employees, suppliers, customers, strategy, objectives, profits, assets, etc.

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Examples
1. A fisherman starting a sea voyage on a fishing expedition may result in loss of life.
2. An infant climbing on a window pane may result in damage or injury.
3. A corporate launching a new product or service in the market place may result in failure
thereby leading to financial and reputational losses.
Business Dictionary defines Risk Perception as Belief (whether rational or irrational) held by an
individual, group, or society about the chance of occurrence of a risk or about the extent,
magnitude, and timing of its effect(s). Risk perception is studied by Corporates, Universities,
Societies, Governments and other bodies to assess the opinions and views of a target audience or
focussed groups to sharpen decision making and judgments where there is lack of clear data on a
subject. The concept of Risk perception is closer to the concept of Cognitive Psychology.
Examples (of more riskier propositions in comparison to above)
1. A family of fishermen starting a sea voyage on a fishing expedition may result in loss of life
OR a fishermen starting a sea voyage on a fishing expedition in rainy season.
2. A home alone infant climbing on a window pane.
3. A corporate launching a new product or service in the market place without market research.
Examples of Probability and relationship with Value of the Risk Outcome -
1. The probability that an actual return on an investment will be lower than the expected return.
2. The probability of a satellite launch succeeding or failing.
3. The probability of a company successfully listing on a stock exchange.
4. The probability of a loss or drop in value, in case of Securities Trading.
5. The risk of developing cancer is estimated as the incremental probability of developing
cancer over a lifetime as a result of exposure to potential carcinogens (cancer-causing
substances).
SA 315 of ICAI defines the term Significant risk in the context of auditing as – An identified and
assessed risk of material misstatement that, in the auditor’s judgment, requires special audit
consideration.
ICAI’s Standard of Internal Audit
Enterprise Risk Management defines Risk is an event which can prevent, hinder, and fail to further
or otherwise obstruct the enterprise in achieving its objectives. A business risk is the threat that an
event or action will adversely affect an enterprise’s ability to maximize stakeholder value and to
achieve its business objectives.
Risk can cause financial disadvantage, for example, additional costs or loss of funds or assets. It

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can result in damage, loss of value and /or loss of an opportunity to enhance the enterprise
operations or activities.
Risk is the product of probability of occurrence of an event and the financial impact of such
occurrence to an enterprise.
SA 315 of ICAI defines Business Risk as
A risk resulting from significant conditions, events, circumstances, actions or inactions that could
adversely affect an entity’s ability to achieve its objectives and execute its strategies, or from the
setting of inappropriate objectives and strategies.
TABLE 1. Important Definitions of Risk, IT Risk, Audit Risk
Source Definition of risk
ISO Guide 73 ISO 31000 Effect of uncertainty on objectives. Note that an effect may be
positive, negative, or a deviation from the expected. Also, risk is
often described by an event, a change in circumstances or a
consequence.
Institute of Risk Risk is the combination of the probability of an event and its
Management (IRM) consequence. Consequences can range from positive to negative.
Institute of Internal The uncertainty of an event occurring that could have an impact
Auditors on the achievement of the objectives. Risk is measured in terms of
consequences and likelihood.
Risk is defined as the possibility that an event will occur, which will
impact an organization's achievement of objectives (The
Professional Practices Framework 2004)
Paul Hopkins Event with the ability to impact (inhibit, enhance or cause doubt
about) the mission, strategy, projects, routine operations,
objectives, core processes, key dependencies and / or the delivery
of stakeholder expectations.
Institute of Chartered Business risk – A risk resulting from significant conditions, events,
Accountants of India, SA circumstances, actions or inactions that could adversely affect an
315 entity’s ability to achieve its objectives and execute its strategies,
or from the setting of inappropriate objectives and strategies.
Oxford English Dictionary (Exposure to) the possibility of loss, injury, or other adverse or
unwelcome circumstance; a chance or situation involving such a
possibility.
International Federation of Uncertain future events which could influence the achievement of
Accountants,1999 : the organization’s strategic, operational and financial objectives.
CIMA Official Terminology, Risk is a condition in which there exists a quantifiable dispersion
2005 in the possible outcomes from any activity. It can be classified in a
number of ways.

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Basel II Operational risk is defined as the risk of loss resulting from

inadequate or failed processes, people and systems or from
external events. This definition includes legal risk, but excludes
strategic and reputational risk.
ICAI – SA 315 A risk resulting from significant conditions, events, circumstances,
actions or inactions that could adversely affect an entity’s ability to
achieve its objectives and execute its strategies, or from the
setting of inappropriate objectives and strategies.
COBIT,ISACA Risk is generally defined as the combination of the probability of
an event and its consequence.
COBIT 5 - defines IT risk as business risk, specifically, the
business risk associated with the use, ownership, operation,
involvement, influence and adoption of IT within an enterprise.
ICAI Risk Based Internal Audit risk relates mainly to the internal and external audit efforts to
Audit Guide achieve its objectives, i.e., provide effective, timely and efficient
assurance to the Board. Audit risk has traditionally been seen
strictly as the risk of incorrect audit conclusions. Contemporary
views however include big-picture audit risks; specifically, that the
internal audit-function is not doing the right things or working in
the best ways.
Even from internal auditing perspective, an organization with well-
established risk management processes decreases audit risk.
Where the organization has a formal enterprise-wide risk
management program (ERM) in place, the internal auditor would
assess it for design adequacy and compliance to decide whether
to rely on the risk register and where found reliable then focus on
auditing the risk responses to significant risks. By relying on
significant risks as determined by management, internal auditing
becomes more efficient.

SA 315 of ICAI requires auditors to design and develop risk assessment procedures. Such risk
assessment procedures comprise of – the audit procedures performed to obtain an understanding
of the entity and its environment, including the entity’s internal control, to identify and assess the
risks of material misstatement, whether due to fraud or error, at the financial statement and
assertion levels.
The International Organization for Standardization defines Risk as the 'effect of uncertainty
on objectives'. In this definition, uncertainties include events (which may or may not happen) and
uncertainties caused by ambiguity or a lack of information. It also includes both negative and
positive impacts on objectives. This definition was developed by an international committee
representing over 30 countries and is based on the input of several thousand subject matter
experts. Very different approaches to risk management are taken in different fields, e.g. "Risk is
the unwanted subset of a set of uncertain outcomes" (Cornelius Keating).

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Financial Risks
NASDAQ defines Financial Risks as the risk that the cash flow of an issuer will not be adequate to
meet its financial obligations. Also referred to as the additional risk that a firm's stockholder bears
when the firm uses debt and equity.
In generic terms finance risk is the possibility that the investment return on an investment will be
different from the historical or expected return, and also takes into account the magnitude of the
difference. This includes the possibility of losing some or all of the original investment.
A free market reflects this principle in the pricing of an instrument: strong demand for a safer
instrument drives its price higher (and its return correspondingly lower) while weak demand for a
riskier instrument drives its price lower (and its potential return thereby higher). For example, a US
Treasury bond is considered to be one of the safest investments. In comparison to an investment
or speculative grade corporate bond, US Treasury notes and bonds yield lower rates of return. The
reason for this is that a corporation is more likely to default on debt than the U.S. government.
Because the risk of investing in a corporate bond is higher, investors are offered a correspondingly
higher rate of return.
In financial markets, one may need to measure market risk, credit risk, information timing and
source risk, probability, model risk, operational risk, liquidity risk and legal risk if there are
regulatory or civil actions taken.
With the advent of automation in financial markets, the concept of "real-time risk" has gained a lot
of attention. Real-time risk is defined as the probability of instantaneous or near-instantaneous
loss, and can be due to flash crashes, other market crises, malicious activity by selected market
participants and other events. A well-cited example of real-time risk was a US $440 million loss
incurred within 30 minutes by Knight Capital Group (KCG) on August 1, 2012; the culprit was a
poorly-tested runaway algorithm deployed by the firm. Regulators have taken notice of real-time
risk as well. Basel III requires real-time risk management framework for bank stability.
1.2 Occupational Health & Safety Advisory Services (OHSAS)
Occupational Health & Safety Advisory Services (OHSAS) defines risk as the combination of the
probability of a hazard resulting in an adverse event, and the severity of the event.
In information security, risk is defined as "the potential that a given threat will exploit vulnerabilities
of an asset or group of assets and thereby cause harm to the organization”.
Economic risks can be manifested in lower incomes or higher expenditures than expected. The
causes can be many, for instance, the hike in the price for raw materials, the lapsing of deadlines
for construction of a new operating facility, disruptions in a production process, emergence of a
serious competitor on the market, the loss of key personnel, the change of a political regime, or
natural disasters.
In terms of occupational health & safety management, the term 'risk' may be defined as the most

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likely consequence of a hazard, combined with the likelihood or probability of its occurring.
According to encyclopaedia, a Chemical accident is the unintentional release of one or more
hazardous substances which could harm human health or the environment. Chemical hazards are
systems where chemical accidents could occur under certain circumstances. Such events include
fires, explosions, leakages or releases of toxic or hazardous materials that can cause people
illness, injury, disability or death.
While chemical accidents may occur whenever toxic materials are stored, transported or used, the
most severe accidents are industrial accidents, involving major chemical manufacturing and
storage facilities. The most significant chemical accident in recorded history was the 1984 Bhopal
disaster in India, in which more than 3,000 people had died after a highly toxic vapour, (methyl
isocyanate), was released at a Union Carbide Pesticides factory.
Under Environmental risk analysis an emerging field practitioners identify the potential events that
could cause damage to the environment and assess the likelihood of an adverse outcome. An
environmental risk assessment (ERA) is a process of predicting whether there may be a risk of
adverse effects on the environment caused by a chemical substance.
Information technology risk, or IT risk, IT-related risk, or Cyber risk is a risk related to information
technology. This relatively new term was developed as a result of an increasing awareness that
information security is simply one facet of a multitude of risks that are relevant to IT and the real
world processes it supports. Security risk management involves protection of assets from harm
caused by deliberate acts. A more detailed definition is: "A security risk is any event that could
result in the compromise of organizational assets i.e. the unauthorized use, loss, damage,
disclosure or modification of organizational assets for the profit, personal interest or political
interests of individuals, groups or other entities constitutes a compromise of the asset, and
includes the risk of harm to people. Compromise of organizational assets may adversely affect the
enterprise, its business units and their clients. As such, consideration of security risk is a vital
component of risk management.
One of the growing areas of focus in risk management is the field of human factors where
behavioural and organizational psychology underpins our understanding of risk based decision
making. This field considers questions such as "how do we make risk based decisions?", "why are
we irrationally more scared of sharks and terrorists than we are of motor vehicles and
medications?"
Positive and negative feedback about past risk taking can affect future risk taking. In an
experiment, people who were led to believe they are very competent at decision making saw more
opportunities in a risky choice and took more risks, while those led to believe they were not very
competent saw more threats and took fewer risks.
Studies and research papers on the subject of Emotional Intelligence have revealed that when
people are anxious or in a state of emotion, they pay close attention to potential threats in the
environment and are highly vigilant so as to preserve themselves and their resources (Eysenck,

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1997; Pacheco Unguetti, Acosta, Callejas, & Lupiañez, 2010). This attention to threat and vigilance
leads people to avoid risk (Loewenstein et al., 2001).
It is common for people to dread some risks but not others. They tend to be very afraid of epidemic
diseases, nuclear power plant failures, and plane accidents but are relatively unconcerned about
some highly frequent and deadly events, such as traffic crashes, household accidents, and
medical errors. One key distinction of dreadful risks seems to be their potential for catastrophic
consequences, threatening to kill a large number of people within a short period of time. For
example, immediately after the September 11 attacks, many Americans were afraid to fly and took
their car instead, a decision that led to a significant increase in the number of fatal crashes in the
time period following the 9/11 event compared with the same time period before the attacks.
The concept of risk-based maintenance is an advanced form of Reliability Centered Maintenance.
In case of chemical industries, apart from probability of failure, consequences of failure are also
very important. Therefore, the selection of maintenance policies should be based on risk, instead
of reliability.
Risk in an organizational context is usually defined as any event or action that can impact the
fulfilment of corporate objectives. Corporate objectives are usually not fully stated or well defined
by most corporates. Where the objectives have been established, they tend to be stated as
internal, annual and change objectives. This is particularly true of the personal objectives set for
members of staff in the organization, where objectives usually refer to change or developments,
rather than the continuing or routine operations of the organization. Refer Table 2 for illustrative
risks that Corporates are exposed to while navigating the business environment.
TABLE 2. Illustrative Corporate Risks
Corporate Functions Risk Areas
Human Resources Poor morale & talent retention
Sales & Marketing Poor Customer loyalty & retention
Operations Inability to Digitize/ automate processes
Treasury Low return on investments
Information Technology Hacking and unauthorized access
New Product development Product failure
Treasury Mismatch in cash flows
Finance & Accounts Unreliable financial statements

Business risks often vary by industry.

ICAI Risk Based Internal Audit Guide provides guidance on the risk classification, sources of risks
and risk categories. Following are illustrated from the said guide:-

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1.3 Classification of Business Risk

Business risks are of a diverse nature. For example, risks can be classified as internal and
external risks; controllable and uncontrollable risks, etc. These classifications help in risk
identification and a better understanding of the interplay between the risks themselves and
between objectives, strategies, processes, risks and controls during risk assessment.
Business Risks: Internal and External
Internal risks arise from events taking place within the business enterprise. Such risks arise
during the ordinary course of a business. These risks can be forecasted and the probability of their
occurrence can be determined. Hence, they can be controlled by management significantly.
Internal factors giving rise to such risks include:
• Human factors as strikes and lock-outs by trade unions; negligence and dishonesty of an
employee; accidents or deaths in the factory, etc.
• Technological factors unforeseen changes in the techniques of production or distribution
resulting into technological obsolescence, etc.
• Physical factors such as fire in the factory, damages to goods in transit, etc.
External risks arise due to events occurring outside the business organisation. Such events are
generally beyond the control of the management. Hence, determining the likelihood of the resulting
risks cannot be done with accuracy.
External factors giving rise to such risks include:
• Economic factors as price fluctuations, changes in consumer preferences, inflation, etc.
• Natural factors as natural calamities such as earthquake, flood, cyclone, etc.
• Political factors as fall or change in the Government resulting into changes in government policies
and regulations, communal violence or riots, hostilities with the neighboring countries, etc.
Business Risks: Controllable and Non-controllable
Controllable risks arise from the events taking place within the business enterprise. Such risks
arise during the ordinary course of business. These risks can be forecasted and the probability of
their occurrence can be determined. Hence, they can be controlled by management to an
appreciable extent (e.g., risks of fire, storms, etc.). Controllable risks need not necessarily be
prevented, but the financial loss can be minimised (e.g., insurance cover can be purchased to
recover the financial loss due to fire).
Uncontrollable risks however, are those that would have a detrimental financial impact but
cannot be controlled. Some uncontrollable risks that are common to many businesses include:
• Recessionary economy.
• New competitor locating nearby.

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• New technology.
Each business faces risks that are unique to that business. Businesses should consider these
carefully and briefly describe what steps would be taken if an uncontrollable risk actually happens
to the business (contingency plan). For example, if the risk of a recession would severely
affect the company,
1.4 Risk Categories by COSO
The COSO framework categories risks as Operations, Financial Reporting, and Compliance. This
categorization is illustrated below:
• Inefficiency and non-effectiveness of operations-e.g., the company does not meet strategic
objectives, the process does not operate efficiently, customers are not satisfied with services
received, etc.
• Financial Reporting-e.g., the absence of a key financial control causes a material error in the
financial statements.
• Non-Compliance with laws and regulations-e.g., the company is in violation of applicable
regulatory requirements.
1.5 Inherent Risk and Residual Risk
Inherent risk is the level of risk assuming no internal controls, while residual risk is the level of
risk after considering the impact of internal controls. For example, the risk of 'over/ understatement
of revenue' without considering any internal controls indicates inherent risk. The above risk when
considered with internal controls in place (say, monthly reconciliation of revenue and follow up,
correction of discrepancies, etc.) indicate residual risk.
The objective of internal controls is to reduce the inherent risk and keep the residual risk within the
organization's risk appetite. The gap between the inherent risk and residual risk shows the
strength of the control and is known as the control score.
1.6 ICAI’s Standard of Internal Audit
Enterprise Risk Management states that Risk may be broadly classified into Strategic,
Operational, Financial and Knowledge.
• Strategic Risks are associated with the primary long-term purpose, objectives and direction
of the business.
• Operational Risks are associated with the on-going, day-to-day operations of the enterprise.
• Financial Risks are related specifically to the processes, techniques and instruments utilised
to manage the finances of the enterprise, as well as those processes involved in sustaining
effective financial relationships with customers and third parties.

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• Knowledge Risks are associated with the management and protection of knowledge and
information within the enterprise.
From a risk management perspective, it is useful to classify the risks so that the mitigation of the
risks can be executed as expeditiously as possible. One common way for risks to be classified is
with respect to impact on the organization, whereby risks with certain impacts have to be
addressed by certain levels of governance.
Risks are normally classified as time (schedule), cost (budget), and scope but they could also
include client relationship risks, contractual risks, technological risks, scope and complexity risks,
environmental (corporate) risks, personnel risks, and client acceptance risks, etc.
Another way is to further classify risks by functional domains. Classifying risks as business,
information, applications, talent and technology is useful but there may be organisation specific
ways of expressing risk that the corporate enterprise architecture should adopt or extend rather
than modify.
1.7 Open Group Standard
The Open Group suggests classifying risks with respect to effect and frequency in accordance with
scales used within the organization. There are no hard and fast rules with respect to measuring
effect and frequency.
Effect could be assessed using the following criteria as an example:
• Catastrophic infers critical financial loss that could result in bankruptcy of the organization.
• Critical infers serious financial loss in more than one line of business leading to a loss in
productivity and no return on investment on the investment.
• Marginal infers a minor financial loss in a line of business and a reduced return on
investment.
• Negligible infers a minimal impact on a line of business' ability to deliver services and/or
products.
Frequency could be indicated as follows:
• Frequent: Likely to occur very often and/or continuously.
• Likely: Occurs several times over the course of a transformation cycle.
• Occasional: Occurs sporadically.
• Seldom: Remotely possible and would probably occur not more than once in the course of a
transformation cycle.
• Unlikely: Will probably not occur during the course of a transformation cycle.

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Combining the two factors to infer impact would be conducted using a heuristically-based but
consistent classification scheme for the risks. A potential scheme to assess corporate impact could
be as follows:
• Extremely High Risk (E): The transformation effort will most likely fail with severe
consequences.
• High Risk (H): Significant failure of parts of the transformation effort resulting in certain goals
not being achieved.
• Moderate Risk (M): Noticeable failure of parts of the transformation effort threatening the
success of certain goals.
• Low Risk (L): Certain goals will not be wholly successful.
1.8 The ICAI Guide on Risk Based Internal Audit
It provides relevant information on the subject of Risk Attributes, Measurement and Risk Score. It
states the following:
All risks have two attributes, viz.
• Likelihood of risk occurrence.
• Risk consequence.
To facilitate understanding and usability in decision making of risk, comparison helps. To enable
comparison a risk score is used. By measuring the two risk attributes a risk score can be derived
for that risk. This risk score is meant for comparison between a cut-off point normally the 'risk
appetite' or comparing to other risks thereby filtering for 'significant risks'.
The measurement of the likelihood of risk is normally against five levels on a scale of 5, viz.
• Remote (score 1).
• Unlikely (score 2).
• Possible (score 3).
• Likely (score 4).
• Almost certain (score 5).
Risk consequences can also be against five levels on a scale of 5, viz.
• Insignificant (score 1).
• Minor (score 2).
• Moderate (score 3).
• Major (score 4).

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• Catastrophic (score 5).

A risk with the lowest level of likelihood, i.e., remote (score 1) can nevertheless have the highest
level of consequences, i.e., catastrophic (score 5). This can be explained by way of an example:
The likelihood of floods causing damage to the distribution network of an electricity distribution
company can be 'remote' but the consequences of damage can be 'catastrophic'. In such a
scenario existence of a contingency plan becomes important.
Risk score for that risk is a numeric multiple of the likelihood of the risk and the risk consequences.
As an example the Board may have a risk appetite of 12 and any risk with a score above 12
becomes significant risk and to be included in the audit plan.

2. RISK & UNCERTAINTY

In his seminal work Risk, Uncertainty, and Profit, Frank Knight (1921) established the distinction
between risk and uncertainty.
Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which
it has never been properly separated. The term "risk," as loosely used in everyday speech and in
economic discussion, really covers two things which, functionally at least, in their causal relations
to the phenomena of economic organization, are categorically different. The essential fact is that
"risk" means in some cases a quantity susceptible of measurement, while at other times it is
something distinctly not of this character; and there are far-reaching and crucial differences in the
bearings of the phenomenon depending on which of the two is really present and operating. It will
appear that a measurable uncertainty, or "risk" proper, as we shall use the term, is so far different
from an immeasurable one that it is not in effect an uncertainty at all. We accordingly restrict the
term "uncertainty" to cases of the non-quantitative type.
Thus, Knightian uncertainty is immeasurable, not possible to calculate, while in the Knightian
sense risk is measurable.
Another distinction between risk and uncertainty is proposed by Douglas Hubbard:
(i) Uncertainty: The lack of complete certainty, that is, the existence of more than one
possibility. The "true" outcome/state/result/value is not known.
Measurement of uncertainty: A set of probabilities assigned to a set of possibilities.
Example: "There is a 60% chance this market will double in five years"
(ii) Risk: A state of uncertainty where some of the possibilities involve a loss, catastrophe, or
other undesirable outcome.
Measurement of risk: A set of possibilities each with quantified probabilities and quantified
losses. Example: "There is a 40% chance the proposed oil well will be dry with a loss of $12 million
in exploratory drilling costs".
In this sense, one may have uncertainty without risk but not risk without uncertainty. We can

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be uncertain about the winner of a contest, but unless we have some personal stake in it, we have
no risk. If we bet money on the outcome of the contest, then we have a risk. In both cases there is
more than one outcome. The measure of uncertainty refers only to the probabilities assigned to
outcomes, while the measure of risk requires both probabilities for outcomes and losses quantified
for outcomes.
Complexity, Volatility, Ambiguity and Uncertainty
If terms are interchanged the acronym becomes VUCA which is used to describe or reflect on the
volatility, uncertainty, complexity and ambiguity of general conditions and situations: -
Complexity
Characteristics: the situation has many interconnected parts and variables. Some information is
available or can be predicted, but the volume or nature of it can be overwhelming to process.
Example: you are doing business in many countries, all with unique regulatory environments,
tariffs, and cultural values.
Approach: Restructure, bring on or develop specialists, and build up resources adequate to
address the complexity.
Volatility
Characteristics: The challenge is unexpected or unstable and may be of unknown duration, but
it’s not necessarily hard to understand; knowledge about it is often available.
Example: Prices fluctuate after a natural disaster takes a supplier off-line.
Approach: Build in slack and devote resources to preparedness-for instances, stockpile inventory
or overbuy talent. These steps are typically expensive; your investment should match the risk.
Ambiguity
Characteristics: Casual relationships are completely unclear. No precedents exist; you face
“unknown unknowns.”
Example: You decide to move into immature or emerging markets or to launch products outside
your core competencies.
Approach: Experiment, understanding cause and effect requires generating hypotheses and
testing them. Design your experiments so that lessons learned can be broadly applied.
Uncertainty
Characteristics: Despite a lack of other information, the event’s basic cause and effect are
known. Change is possible but not a given.
Example: A competitor’s pending product launch muddies the future of the business and the
market.

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Approach: Invest in information-collect, interpret, and share it. This works best in conjunction with
structural changes, such as adding information analysis networks that can reduce on-going
uncertainty.
(Source: - Harvard Business Review/hbr.org/what-vuca-really-means-for-you)

3. CLASSIFICATION OF RISKS
3.1 Nature of Risks
Risk may bear positive or negative results or may simply result in uncertainty. For example where
the Municipal authorities of a metropolis decide to implement a Metro Rail project; it is with the
objective of reducing traffic and travel time for city residents, however, if there are frequent fatal
accidents at the Metro Rail resulting in loss of human life and public property, the decision of
Municipal authorities to implement Metro Rail project would be seen in a different light. Therefore,
risks may be considered to be related to an opportunity or a loss or the presence of uncertainty for
an organization. Every risk has its own unique nature and characteristics that require study,
management or analysis.
3.2 Categorisation of Risks
According to Paul Hopkins (in Fundamentals of Risk Management) risks are generally divided into
three categories:-
• Hazard (or pure) risks;
• Control (or uncertainty) risks;
• Opportunity (or speculative) risks.
Pure Risks are associated with uncertainties which may cause loss. In a pure risk situation, a loss
occurs or no loss occurs – there is no possibility for gain. These uncertainties may be due to perils
such as fire, floods, etc. or may arise from human action such as theft, accident etc. There are
certain risk events that can only result in negative outcomes such as fire accidents or leakage of
harmful chemicals from a manufacturing plant. These risks are hazard risks or pure risks, and
these may be thought of as operational or insurable risks. A good example of a hazard risk faced
by many organizations is that of theft. There are different types of pure risks:
• Personal risks - It includes early death, sudden accident and disability, unemployment, etc.
• Property risks - reduction in value of assets due to physical damage, fire, theft, etc.
• Liability Risks - the risk of legal liability for damages accruing to customer, suppliers, vendors,
etc. Such risks are also connected with compensation payable to employees for injuries and
other harm afflicted in the workplace.
Above situations all come under the category of pure risks and are insurable.

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Fundamental Risks are impersonal in nature. They are present in nature and the economy, and
are beyond the control of man. Their effect is pervasive and usually impacts a large group of
people. Earthquakes, war, inflation, mass unemployment, etc., are examples of such fundamental
risks. Generally, these risks are not insurable and it is left to the Government to deal with the
effects of these events. However, in situations where the occurrences are irregular and the impact
in minimal, the insurers can venture to insure these risks.
Particular Risks have their origin in individual events which can be partially controlled. They occur
due to the action of the individuals, for example, meeting with an accident while crossing the road.
These risks are insurable with conditions.
Dynamic Risks may arise due to changes in the economy like fluctuations in price levels,
consumer references, distribution of income, product development, shifts in technology, etc. These
are called Dynamic Risks. As they are less predictable, generally, they are not insurable.
Control risks are associated with unknown and unexpected events. They are sometimes referred
to as uncertainty risks and they can be extremely difficult to quantify. Control risks are often
associated with project management. In these circumstances, it is known that the events will
occur, but the precise consequences of those events are difficult to predict and control. Therefore,
the approach is based on minimizing the potential consequences of these events.
There are two main aspects associated with opportunity risks. These risks/dangers are associated
with taking an opportunity and not taking the opportunity. Opportunity risks may not be visible or
physically apparent, and they are often financial in nature. Although opportunity risks are taken
with the intention of having a positive outcome, this is not guaranteed. Opportunity risks for small
businesses include moving a business to a new location, acquiring new property, expanding a
business and diversifying into new products.
Speculative Risks have three possible outcomes: loss, no loss or gain. Examples of such risks
include the decision to invest in some shares etc. The statistical techniques used in insurance
cannot be applied to speculative risks. Further, these risks are deliberately taken with the hope of
gain. Generally, speculative risks are not considered insurable.
It may be noted that there is no ‘right’ or ‘wrong’ classification of risks. Risks can be grouped
according to their nature, estimated cost or likely impact, likelihood of occurrence,
countermeasures required, etc.
For example, Credit risk, is classified according to the likelihood of the collection of accounts receivable.
The most important issue is that an organization adopts the risk classification system that is most
suitable for its own circumstances.
Risks which occur even with no changes in the economy are classified as Static Risks. These
include losses due to perils like fire, theft and dishonesty of individuals. Over a period of time,
certain regularity may be observed in these occurrences and they may become predictable. Such
static risks are more insurable than Dynamic Risks.

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Example
In order to understand the distinction between hazard, control and opportunity risks, the example
of the use of machines is useful. Technical snag while operating a machine is an operational or
hazard risk and there will be no benefit to an organization suffering a technical breakdown in its
manufacturing operations. When an organization installs or upgrades a machine, control risks will
be associated with the upgraded project.
The selection of new machine is an opportunity risk, where the intention is to achieve better results
by installing the machine, but it is possible that the new machine will fail to deliver all of the
functionality that was intended and the opportunity benefits will not be delivered. In fact, the failure
of the functionality of the new machine may substantially undermine the manufacturing operations
of the organization.

4. TYPE OF RISKS
Events can have negative impact, positive impact, or both. Events with a negative impact
represent negative risks, which can prevent value creation or erode existing value. Events with
positive impact may offset negative impacts or represent opportunities. Risk and opportunity
management are closely related, organisations with superior competencies and knowledge
database attempt to convert negative risk events into positives by creating a focussed group of
experts who brainstorm on breakthrough ideas that could help the organisation move in a positive
direction. This is a contemporary phenomenon and is commonly referred to as “catching the ball”
or “idea funnel”. Risk management is all about value protection, maximizing gains from risk
outcomes and seizing the opportunities by formulating management action plans. Disruptive start
up culture is all about identifying real life problems and converting them into business
opportunities.
According to webopedia - Risk as part of GRC (Governance, Risk and Compliance) Management
is the ability to effectively and cost-efficiently mitigate risks that can hinder an organization's
operations or ability to remain competitive in its market.
Businesses face different type and extent of risks, few may cause serious loss of profits or even
bankruptcy. Large companies have extensive "risk management" departments; smaller businesses tend
not to look at the issue in such a systematic way but may have a more hands on approach to risk
management. A successful business needs a comprehensive, well-thought-out business plan.
However, business is dynamic; things change, and the best-laid plans can sometimes appear out-dated
in quick time. When the company’s strategy becomes less effective in the market place and it struggles
to reach its goals as a result; the company is facing strategic risks or model risks. It could be due to
technological changes, a powerful new competitor entering the market, shifts in customer demand,
spikes in the costs of raw materials, or any number of other large-scale changes.
Business risks can arise due to the influence by two major risks: - internal risks (risks arising from
the events taking place within the organization) and external risks (risks arising from the events

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taking place outside the organization).

Risks are caused on account of two factors internal and external. Further, these internal factors
are controllable and uncontrollable. Let us look at the table below that highlights some examples of
internal and external factors:

Internal Factors External Factors

Controllable Controllable
• Stability and financial position of the • Compliance with regulatory changes
entity Uncontrollable
• Labour strikes • Economic conditions
• Machine failure • Floods
• Staff morale • Earthquake
Uncontrollable • Market/environment
• Accidents
• Attrition of people
• Technological change
• Frauds

In addition to the business risks, organisation can have following major risks (illustrative) which will
be applicable to any organisation:-
• Financial risk - These risks are associated with the financial assets, structure and
transactions of the particular industry.
• Credit risk - The risk of loss arising from outright default due to the inability or unwillingness
of the customer or counterparty to meet their commitments. Credit risk is the probability of
loss from a credit transaction. It is also called as default risk.
• Liquidity risk - The potential inability to meet commitments as they fall due. It arises
whenever the bank is unable to generate cash to meet out its liability payment obligations or
increase in assets or its failure to manage the unplanned decreases or changes in the
funding sources. Liquidity risk also arises on account of its failure to address the changes in
the market conditions that affect its ability to liquidate its assets quickly and with minimal
losses.
Liquidity risk may arise due to changes or variations in the market conditions such as,
volatility of rate of interest or the Foreign exchange rate /Investment mismatch or risk or poor
economic conditions like depression / inflation / loss of confidence in the business by its
customers/ rumors about the business and its effects of run on the liquidity/ failure of some of
the banks where its deposits got struck or blocked or war like situations with the enemies of
state are some of the examples where the businesses will be facing liquidity crisis as it may
cause heavy out flow of funds.

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• Market risk - The risk of losses caused by adverse changes in the market variables such as
interest rate, Foreign Exchange rate, equity price and commodity price. RBI has defined the
Market Risk as the possibility of loss to a bank caused by the changes in market rates /
prices. Market risk is the possibility for an investor to experience losses due to factors that
affect the overall performance of the financial markets in which he has invested money.
Market risk, also called "systematic risk," cannot be eliminated through diversification, though
it can be hedged against. Sources of market risk include recessions, political turmoil, and
changes in interest rates, natural disasters and terrorist attacks.
• Operational Risk- The risk associated with the operations of an organization. It is the risk of
loss resulting from failure of people employed in the organization, internal process, systems
or external factors acting upon it to the detriment of the organization. It includes Legal Risk
and excludes strategic and Reputational Risks as they are not quantifiable.
• Strategic Risk - The current and prospective impact on earnings, capital, reputation or good
standing of an organization arising from its poor business decisions, improper implementation
of decisions or lack of response to industry, economic or technological changes. Failure of
strategies will adversely impact the business objectives and attainment of the goals.
• Compliance Risk – It includes material financial loss or loss of reputation which may occur
as result of its failure to comply with the laws includes, regulations, rules, related self-
regulatory organization, standards and code of conduct applicable to its business activities.
• Regulatory Risk - Regulatory Risk arises due to changes made in policies and procedures
by the regulators viz, RBI, Central and State Governments, SEBI, IRDA, etc. Withdrawal of
licenses, change in capital adequacy requirements, change in NPA norms etc. may be
grouped under this category. Any changes in the rules and regulations which may have a
negative impact on the business activities can be classified under this risk.
• Reputation risk – Adverse publicity regarding an entity’s practices will lead to a loss of
revenue or litigation. Any event which affects the name or brand image of the entity is
Reputational Risk. Any adverse publicity, news coverage, comments etc. has the ability to
dent the trust created by the entity and becomes detrimental to the business of the entity.
• Legal risk - Arises from the uncertainty due to legal actions or uncertainty in the application,
interpretation of contracts, laws or regulations. Legal risk is the risk arising from failure to
comply with statutory or legal requirements.
• Interest rate risk - Risk where changes in the market interest rates might adversely affect
the Net interest Income earnings. It is the threat that interest paid may be more than the
interest collected resulting in financial loss.
• Foreign exchange risk- Risk of loss that the entity may suffer on account of adverse
fluctuations in the exchange rate movements in currencies.
• Management risk – Risk of management interference in day to day operations and putting

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undue demands and restrictions on staff. Quality of senior management affects the decision
making and contributes to management risk. It means the risks associated with ineffective,
destructive or underperforming management, which hurts shareholders and the company or
fund being managed. This term refers to the risk of the situation in which the company and
shareholders would have been better off without the choices made by management.
• Staffing risk – Risk of not employing the right person for the right job. Poorly drafted job
descriptions, inadequate background verifications and inexperienced personnel contribute to
staffing risk.
• Technology risk – Risk of not keeping pace with the fast changing technologies for business
operations. Usage of outdated technologies could impact the business operations adversely
thereby resulting in loss of reputation, market share, customers, etc.
• Business continuity risk – Risk arising from inability to restore operations immediately in
the event of an incident / disaster.
• Information (data security) risk – Risk of unauthorized access to data. Poor access
controls both at the network level and application level give rise to this risk. While information
has long been appreciated as a valuable and important asset, the rise of the knowledge
economy and the Digital Revolution has led to organizations becoming increasingly
dependent on information, information processing and especially IT.
• Country risk – Helps to address the issues of identifying, measuring, monitoring and
controlling country exposure risks. Procedures are in place for ensuring that necessary steps
are taken as per RBI guidelines.
• Fraud risk – Risk of control failures, management override and deliberate acts of omission
and commission that lead to financial losses.
• Price risk - Probability of loss occurring from adverse movement in the market price of an
asset.
• Process risk – Inability of the management to meet its process related objectives on account
of failed activities in a business process. It is a risk of loss resulting from failure of
internal processes, people and systems or from external events.
• Security Risk - A person or situation which poses a possible threat to the security of
something. Security arrangements risk - risk which arises from vulnerability of security
systems is termed as security arrangements risk.
• Governance risk - Refers to in-effective, un-ethical management of a company by its
executives and managerial levels.
• Safety risks - These are the most common and will be present in most workplaces at one
time or another. They include unsafe conditions that can cause injury, illness and death.
Safety Hazards include: -

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♦ Spills on floors or tripping hazards, such as blocked aisles or cords running across the
floor.
♦ Working from heights, including ladders, scaffolds, roofs, or any raised work area.
♦ Unguarded machinery and moving machinery parts; guards removed or moving parts
that a worker can accidentally touch.
♦ Electrical hazards like frayed cords, missing ground pins, improper wiring.
♦ Confined spaces.
♦ Machinery-related hazards (lockout/tag out, boiler safety, forklifts, etc.).

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