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Fundamental of Risk Modeling

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Fundamentals of Risk Modeling

Risk modeling can be defined as representing a system mathematically, mainly when

dealing with distribution. For the modelers to understand risk management's probability, they

conduct questions that are relevant to the topic. Collecting this information is a significant

challenge; getting the people to decide well enough with the models is the other one. This essay

aims to illustrate how risk models are of help, modeling various risks, and how organizations

make decisions with risk management.

Risk management is divided into three categories, namely control (or uncertainty) risks;

hazard (or pure) risks; and opportunity (or speculative) risks. They are categorized according to

the outcomes, positive or negative. From this, the organization chooses the most appropriate risk

classification system to encounter their issues correctly (Paul, 2010).

Control (or uncertainty) risks are risks that give rise to uncertainly about the situations'

outcome. Mostly, they are associated with the management of the project. This type of risk can

be considered so that it can achieve the planned business outcome.

Hazard (or pure) risks are risk events that have a negative outcome as the only results. They

can be described as insurable or operational risks. The most known event that many

organizations face and are an excellent example of hazard risk is theft.

Opportunity (or speculative) risks are the risk type taken by an organization for positive

outcomes. They are most enacted in organizations' investments because they have benefited from

them.
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Risk classification systems

Risk classification is done depending on the risk's attributes of nature and the natural

effects, but in this case, it will be classified according to the origin. The other way of risk

classification is the consideration of impact's nature. Organizations end up preceding on the risk

classifications which is suitable to their natural activities. They keep in mind to choose risk

classification that is relevant to their organization. Some types of risk classes include business

risk, financial risk, and non-business risk (Verma, 2021)

Financial risk is the commonly preferred risk for any business. The table below

summarizes financial risk (Verma, 2021).

(Verma, 2021).
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Importance of Risk Models

Risk managers know their part to play in any organization. In many circumstances,

employees fail to identify these risk managers, which is a problem. To show that the Risk Model

has importance, the employees should keep in mind the following points.

i. Everyone has to manage risk.

As we know, every organization encounters risk. Sometimes the risk is unalterable for

achieving success. Time risk management can be described as "the department of no." estimating

all the risks is not its purpose but minimizing potential consequences of risks that are negative is

its purpose. When the employees work with risk managers, they will make wise decisions hence

improving reward chance (Webb, 2021).

ii. Risk management makes jobs safer.

Risk managers' critical parts play health and safety. They find out the areas with issues in

an organization then settle them. To identify the losses and injury trends, they use data analysis,

and they provide the solution to solve them. The most exciting part is that employees get

benefited. Everyone prefers to be in safe workplaces, which can happen only in risk management

(Webb, 2021).

iii. Risk management enables project success.

Risk managers can help employees' projects successful without considering the associated

department. Effective risk management gives room for knowing the strengths, opportunities,

weaknesses, and threats of the project (Gouda, 2016). Successful risk managers define the

procedures of encountering potential risks to avoid the problems in doing. They recognize risk

management as significant because the project achievements depend on the planning, preparation
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results, and evaluation that plays a role in achieving set goals. In simple terms, risk management

helps the employees to reduce the dangers of potential risk by early identification, which gives

appropriate action to be taken.

Construction of risk management models

A business needs to develop a model on approaching various risks for it to succeed or avoid

unnecessary sideshows. The following facts should be taken into consideration in choosing the

risk model; proportion level of risk of the organization, business orientation, alignment to other

businesses, comprehensibility, system, and adaptability to any change (Webb, 2021).

Components of a risk management model

Designing a successive risk management model involves components that must be undertaken

and the involved business's framework. Models should be designed in a way that their

implementation should bring impact to their businesses. These components include; protocols,

strategy, and risk architecture. These components are crucial in the making of a risk management

model. Missing any of them makes the model vulnerable to similar occurrences if not dealt with

and its effects prevented from occurring. (Webb, 2021)

Risk architecture

Involve defining the roles and responsibilities of everyone involved in the model,

communication framework, and the right reporting structure. It outlines who is involved and how

the model is going to work.

Risk protocols

Defines the guidelines in risk management in the business, involving rule and procedures to

undertake and the execution methodology, technique, and tools to be applied in neutralizing risk

Risk strategy

These are the policies providing a framework on how risk is managed, and they include

appetite and attitude to manage risk at all levels in a business.

Risk management framework

This is the procedural network involved in risk management, with the internal environment

setting the basis for how risk will be handled by setting the management's objectives in

identifying events that can cause risk. There should be a clear distinction between opportunities

and risks both from internal and external environments. Analysis of risk and determining its

possible impact and deciding how to handle it; eliminate, substitute, or share it. Implement set

policies and procedures for effective execution and findings communicated to the relevant

authority for action to be taken appropriately. The entire process is monitored appropriately, and

modification should be taken to prevent similar risk occurrence and a definition drawn on how to

deal with similar events. (Paul, 2010)

Risk management modeling techniques

Organizations must devise techniques for determining, analyzing, and handling risk, both

internal or external. The choice of technique depends on the structural framework of the

organization. Simple and linear organizations prefer simple and traditional techniques, while

complex-oriented models take graphical methods and techniques. This approach develops two

known techniques, cognitive and Bayesian techniques. (Gouda, 2016)

Cognitive mapping technique

Developed upon personal constructs theory developed by George Kelly in the 1990s.

According to the theory, people tend to predict future outcomes by taking action to achieve what

they need in the future. Risk is analyzed individually in relation to the constituent elements with

a visual connection to the risk representation. Usually, it's the first technique for the linear

organization due to its direct approach to organization. The technique received earlier support

from Fran Ackermann, Steve Cropper, and Colin Eden. Hierarchy is fundamental in the

construction of the framework of this technique. (Joshua& Paola, 2013)

Bayesian technique

It was developed by Thomas Bayes around 250 years ago. It involves complex models that

can be described visually by a cyclical graph that defines causes and effects and their relation.

These graphs are comprised of nodes and arcs, with nodes representing variables arcs the

relationship between variables. They don't explain that a particular outcome will happen but how
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the modeler thinks and predicts how it will happen depending on the pre-existing condition and

experience.

Bayesian theorem

A formula represents the technique

p(B/A) =p(B/A)/p(B)*p(A)

p(A|B) the probability of event A occurring in that event B occurred already

p(A) the probability of occurrence event A

p(B|A)/p(B) the probability of event B occurring given that event A has occurred, divided by

the probability of event B occurring. (Joshua& Paola, 2013).

Measurement and Aggregation of risk management models

In order to measure and aggregate risk management models accurately, it is important to study

the weakness of various models and their drawbacks to improve on them. Measurement of

specific operational risks involves historical evidence or simulated information, or both

combined. Measurement involves three basic approaches; basic indicator involving the

calculation of a single indicator to represent overall exposure, standardized indicator determines

the operational risk by multiplying a wider financial indicator by the loss experience. And

finally, the advanced approach calculates the operational risk by combining the qualitative,

quantitative formulas and the internal loss data.

Risk aggregation entails recognition and rating to determine the predicament facing an

organization, project, or strategy. It should be the starting point for the risk management model

to serve its purpose of identifying significant risks for proper action to be taken. (Paul, 2010).

Conclusion

Any organization project or strategy is vulnerable to risk. Designing workable models of risk

management defines the probability of minimizes the occurrence of a particular risk that can

cause harm, either financial or physical. Well-structured models represent the readiness of an

organization to neutralize risk. Documentation is key in risk management, with clear evidence of

occurrence and steps undertaken to prevent similar events. In designing the risk management

models’ organizations policies, they should align with the structure for them to avoid conflict of

operation.
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References

Gouda, A. (2016). Why is Project Risk Management Important? LinkedIn.

https://www.linkedin.com/pulse/why-project-risk-management-important-adarsh-gouda.

Joshua, C. and Paola, L. (2013). The operational risk modeling framework

Paul, H. (2010). Fundamentals of risk management: understanding, evaluating, and implementing

effective risk management

Verma, E. (2021, February 1). Financial Risks and Its Types: Simplilearn. Simplilearn.com.

https://www.simplilearn.com/financial-risk-and-types-rar131-article.

Webb, R. (2021, January 6). 10 Reasons Risk Management Matters for All Employees.

https://www.clearrisk.com/risk-management-blog/risk-management-matters-for-all-employees-

0-0-0.

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