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Risk Analytics: Methods and Benefits

July 30, 2014

All businesses must assume risk to create profits.  So dealing with risk is inherent in the nature of business. The way that these risks are managed can vary greatly, however. Taking on risks smartly can cause an organization to thrive while assuming foolish risks can drive the same organization into the ground. Therefore, wise managers use all of the tools at their disposal to manage risk. The following risk references are applicable to multiple industries.

The first step in managing risk is to determine what the most important risks to the organization are.  Many of these are obvious and handled on a daily basis. For example, know that they need to offer their tickets at a competitive price or customers will go elsewhere. In addition to these easily visible risks, there are many risks that are inherent in the business environment but aren’t managed on a regular basis. These can include supply chain risk, operational risk and security risk.

Part of a thorough analysis of a company’s risk profile also includes the decision of what is in scope. For an airline, a risk may be that one of the countries that they serve undergoes a revolution and the airport can no longer be used.  While this is a real risk, the analyst may decide that it is low enough likelihood that it isn’t worth considering.

After deciding what risks are relevant, the next step is to prioritize them. Prioritization will be determined by both the probability of the risk actualizing and the impact of that event on the organization. High impact risks that are likely to materialize will be the highest priority to plan for.

The highest priority risks often contain a quantitative component that can be analyzed using statistical methods. In the case of the airline, high fuel prices may be one of the critical risks. There are a number of quantitative analyses that can be performed to manage this risk. For example, fuel prices could be forecast based on historical prices to look for any seasonal trends. An analysis could also be conducted of whether flying larger planes or smaller planes would result in an overall cost savings.  Airlines typically hedge against fuel price and numerical analysis would determine how large of a hedge is necessary.

Once a statistical model has been built to manage the risk, then this model can be integrated into the company’s processes. Stakeholders can rest easy knowing that the optimal strategy is leading decisions on a daily basis.

Risk analytics methods, which used to be a luxury and were practiced by only a few large companies, are becoming a necessity in the ever-changing modern business environment.  The company that uses these tools to maximize their edge will slowly but surely leave their less analytical competitors behind.