In risk management, risk assessments are tools used to assess operational risks so an organization can effectively mitigate and manage those risks at an acceptable level. The goal of the risk assessment process is to identify hazards, then analyze and evaluate the risks those hazards pose.
Risk itself falls into many buckets. In this article, we’ll be discussing inherent and residual risk, specifically, so as to decipher the difference between inherent and residual risk assessments and understand the operational risk management software capabilities needed to get the best out of both.
What is inherent risk?
So, what is inherent risk? Inherent risk is the level of risk in place before actions are taken to alter the risk’s impact or likelihood.
Another way of thinking of inherent risk is the amount of risk that exists when some threat goes untreated or unaddressed. The less an organization tries to manage risk, the more inherent risk there’s likely to be.
What is residual risk?
Now, what about residual risk? Residual risk, on the other hand, is the level of risk that remains following the development and implementation of the organization’s response.
Residual itself means remaining after the greater part or quantity has gone. And so, the best way to think of residual risk is the level of risk that remains after implementing a set of controls to reduce inherent risk.
Inherent vs. residual risk
What are the main differences, then, between inherent and residual risk?
Simply put, where inherent risk is the current risk level, residual risk is whatever risk is left over after controls are applied.
Components of inherent risk
Why does each matter? For one, it’s hard to keep an organization’s risks at an acceptable level by developing and deploying risk controls without first quantifying inherent risk.
Additionally, inherent risk itself has several elements that auditors can use to identify potential risks, the probability of those risks occurring, and their potential impacts.
Components of inherent risk include:
Business type
How the company conducts its day-to-day business operations. Inherent risk necessarily increases if the organization can neither adapt to external factors nor navigate with a dynamic environment.
Execution of data processing
A company’s capacity to use technology and computers to convert raw data into usable information. Inability to analyze data effectively increases inherent risk.
Complexity level
How a company records complicated transactions and operations. Higher complexity usually introduces more inherent risk by increasing the risk that work will be done improperly.
Poor management
It goes without saying disengaged or oblivious management increases organization’s level of inherent risk as employees are likely to make significant errors without oversight.
Ignorance and/or integrity of management
Similarly, senior leadership that acts unethically increases a business’ inherent risk. Such companies are likely to suffer reputational if not regulatory harm.
Previous results on audits
Past behavior is often a blueprint of future behavior. Such is the case with past audits that were found to be inadequate, discriminatory, or purposefully disregarded serious misstatements.
Transactions among related parties
Transactions among related parties increase the potential for conflicts of interest, thereby increasing inherent risk.
Inherent risk assessment vs. residual risk assessments
What of the risk assessments that flow from each type of risk?
Well, an inherent risk assessment identifies and understands the risks associated with a particular activity, process, or project.
The primary challenge with inherent risk assessments, however, is that they don’t explicitly consider which controls are being included or excluded.
Meanwhile, the residual risk assessment considers the effectiveness of existing controls and risk mitigation measures in an effort to determine the level of risk that remains after implementing these measures.
The benefit of the residual risk assessment is that it helps organizations understand the extent to which the implemented controls have reduced the likelihood and impact of the risks.
Developing the risk assessment
How about putting together a basic risk assessment?
Well, the risks identified through the risk identification process are usually categorized into any of the following categories:
- Strategic
- Financial
- Operational
- Compliance
- Etc.
However, the steps between assessing inherent risk and evaluating residual risk, although varying across different types of business, involve the following steps:
Risk response
Management devises risk responses across various levels based on risk analysis (considering impact and likelihood) and the defined risk tolerance level. Responses generally encompass acceptance, avoidance, reduction, and sharing strategies.
Implementation of controls
Controls are generally established in critical operational areas where acceptance is deemed too risky, and avoidance or sharing isn't feasible or practical.
What is a risk control, though? A control can be any measure that mitigates or reduces risk, often entailing additional activities to ensure proper process execution.
Testing and evaluation
Following the implementation of controls, testing is typically conducted to ensure efficiently. This process is meant to instill confidence that controls have effectively reduced risk to an acceptable level.
Corrective measures
Should controls be deemed weak, absent, or malfunctioning, corrective measures become necessary. Corrective measures should be documented and integrated into the entity's risk assessment plan with a specified timeline.
Since testing can be time consuming and not always feasible, ongoing monitoring and periodic reviews of control design can serve as an alternative to ensure timely and accurate execution of activities.
Inherent vs. residual risk assessments; which to pick?
Inherent and residual risk assessments aren’t a matter of “either or” but “both and.” Both types are complementary, contributing to a comprehensive understanding of risks.
Given the nature of inherent risk, inherent risk assessment is usually conducted at the beginning of the risk management process. For the same reason, residual risk assessment takes place after controls and mitigation measures have been put in place.
How to get the balance right?
Teams should first identify and comprehend the risks associated with a specific activity or process. Inherent risk assessment, here, helps in establishing a baseline understanding of risks, considering various factors.
Then, the likelihood and impact of these risks are evaluated to assess their severity and frequency.
The benefit, therefore, of pursuing inherent and residual risk assessments is to gain a comprehensive understanding of the risks companies face and the effectiveness of their risk management efforts. Both assessments, as has been noted, offer value by providing insights into different phases of the risk management process and guiding decision-making, ideally leveraging robust, centralized risk data to effectively mitigate risks.
As a result, organizations should adopt a systematic approach to assess and compare inherent versus residual risk assessments. That approach might look something like this:
- Start by identifying and comprehending the risks associated with a specific activity or process.
- Then, evaluate the likelihood and impact of these risks to determine their frequency and severity.
- Design and implement controls and risk mitigation measures to address the identified high-priority risks.
Noggin’s operational risk management software
When it comes to adopting a systematic approach to assess and compare inherent versus residual risk assessments, organizations should consider the nature of the risks, external influences, and internal vulnerabilities to establish baseline risk exposure and shape risk mitigation strategy.
From there, they should concentrate on the disparities in likelihood and impact before and after implementing controls.
What are some digital technologies to help facilitate the risk assessment process? Noggin’s operational risk management software helps organizations proactively identify, assess, and mitigate potential risks that could cause operational failures or disruptions to their normal operations.
How so? Noggin’s risk assessments capability lets teams proactively identify, assess, and manage operational risks through a centralized workspace that provides a holistic view of risks, and streamlines risk assessment processes while fostering effective stakeholder collaboration and communication.
But don’t just take our word for it. Request a demonstration to see Noggin in action for yourself.
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