It's all about the Target (risk assessment)

In my previous post I commented on the importance of adding a “Target” risk position to the traditional "Inherent" and "Residual" risk assessments, and the linkage to the Risk Appetite. More importantly, the “Target” level for any risk provides a focus on the future.

Let me explain.

Inherent to Residual: Inherent risk is the level of risk before remediation. This is important to ensure that we are focusing on the areas of risk that represent this greatest threat or opportunity for the entity. Inherent risk scoring is subjective, but then so is almost all risk scoring. Yet an assessment, subjective or quantified, of the risk before controls or other remediation ensures that we invest our limited resources on the areas that pose the greatest to achievement of the entity's objectives.

So we’ve assessed the Inherent risk, and we have applied controls for remediation, mitigation, etc. Now we have our “Residual” or “Net” risk position. Again, this is by nature subjective, and fraught with assumptions. But it does provide an assessment of our current state of risk and the level of risk that is being taken by or accepted by the entity. But this is subjective. And it will be wrong.

There will be too many missing controls, controls that are functioning ineffectively, mitigation that is unfocused or not in place. The assessment of the Residual risk position provides a snapshot of the current situation, with no insights into either the level of risk that is acceptable, the actual level of risk being taken, or the level and type of risks that the entity wants to take.

Target: And to we get to the “Target” risk level or assessment. What level of risk does the entity want to take, and what level of risk is acceptable. This fundamentally an assessment of the desired future-state of the risk environment that the entity wishes to work within. And yes, this too shall be subjective. It will also probably be achievable.

As Risk Managers we need to consider and advise on the level of acceptable or desirable risk to be taken or accepted by an entity, across the spectrum of risks. This means that we need to assess not only the raw (Inherent) risk environment and support the allocation of resources to highest or least desirable risk areas, and of course allocation of resources to those areas where we want to take risk. 

We also need to work with management to objectively assess the desired, or acceptable level of risk to take; the Risk Appetite. This should be done globally, and should be done at the level of each identified and recorded (and managed) risk. This is our Target risk level for each risk.

Now, and only now, can we meaningfully assess our “Residual” level or risk, and determine if that level of risk is appropriate. 

If our current (“Residual” or “Net”) equals our Target, then we are running at our desired level of risk. And if we are not, then we now know that our desired future state does not equal our current risk managed state for this, and all other risks where Residual does not equal Target. 

Example of Residual to Target tracking

In the example above, a number of interesting observations can be made, including that the Residual and Target risk assessments change, as risks are reviewed by the Risk Owners. It is also clear that Residual are Target are not the same. Within the data there will probably be a number of individual risks where the Residual assessment equals the Target assessment; the current risk situation for those risks equals the entity's Risk Appetite for those specific risks.

So why does Residual not equal Target? There are three possibilities:

1. Our control environment is ineffective and or does not include all the controls that are already in place to manage the risks (and these then need to be identified).
2. Our aspirational level of risk management for risk is too high.
3. Conversely, we are over-controlled (where Residual is lower than Target for specific risks) and we are potentially stifling the business through excess controls.

And when we determine that our Residual risk position does not equal our Target risk position, we have four option:

1. Accept that it will not be possible to achieve the desired Risk Appetite for this risk, and, through a Delegation of Risk Authority process, change our Risk Appetite and therefore our Target level for this risk to equate to the current Residual risk level.
2. Subtly different, but we may determine that the Risk Appetite is not right, and that we do want to accept, or take, more of this risk, and therefore change the Target.
3. Identify the controls that are not effective and implement improvement programmes or introduce new controls.
4. Confirm that we are over-controlled and look at which controls are not actually required, or are burdensome and should be replaced with monitoring controls.

What is the role of Internal Audit in this?

The Internal Audit function provides some assurance that the system of internal controls is effective. This requires Internal Audit to determine what areas of business activity they will review. This selection should be risk-based, which means starting with the risk register and consider a balance between this Highest “Inherent” risk areas, and the highest “Residual” risk areas.

As part of each Internal Audit, the assessed level of Target risk should be considered, and Internal Audit should then perform an audit programme designed to confirm (or otherwise) that management’s assessment of the effectiveness of controls is accurate. If the controls are effective, and these controls have been determined to bring the entity to within Risk Appetite, than Internal Audit’s role is limited to questioning the appropriateness of the Risk Appetite. (Note I say question, not set, as that is the role of senior executives and the Board, other others within their Delegation of Risk Authority).

Where the Residual risk level does not meet the Target, Internal Audit should be determining if this is because the controls are ineffective, or because the control environment provides inadequate coverage of the risk. In which case, new controls may be appropriate.

In all cases, Internal Audit should be determining if Management's assessment of the effectiveness of the control environment matches the evidence provide to Internal Audit. If management's assessment is correct, and there remains a delta between the Residual and Target, and senior management and/or the Board are aware, then there is no Internal Audit finding other than the fact that senior management and/or the Board are aware of the difference, and are aware of and support management's plans for remediation.

It's all about the Future

The core message however is that the Inherent risk position represents a “past” with no controls, the Residual risk position represents the present (as assessed by management), while the Target risk represents the future, or desirable control and risk management state, and is one of the enunciation of the entity's Risk Appetite.

The question we ask of Risk Owners is: What are you doing to get from the Residual risk position to the Target risk position, and when will you get there?

Risk Acceptance - the need for a Delegation of Risk Authority (DRA)

Over too many years, when pointing out a risk or situation, either management of below may respond with "it's okay, we've accepted that risk".

Really? Who accepted that risk, and did they have the authority to accept that much risk on behalf of the business. In too many cases the risk identified was significant, and if presented to senior management or the Board, that risk would not have been "accepted", at least not without consideration of the implications and costs of remediation or reduction of the risk.

What actually happened is that the person or people dealing with the risk have been unable to quantify or otherwise clarify the risk and potential impact, or develop a costed and realistic plan to mitigate the risk. Because of this, they have failed to convince themselves of the severity of the risk, and therefore are unable to communicate that exposure to senior management. Having failed to effectively communicate, they fall back on "we've accepted that risk". 

Too often what was missing was an actual assessment of the risk, either subjective or quantitative where possible. Included in such as assessment should be a definition of the existing controls and an assessment of the effectiveness of those controls.

Controls exist to provide confidence that risks are being managed. As such, on a quarterly, six-monthly and for some annual basis, management owners of controls should confirm that the controls associated with risks are functioning and are effective. Evidence should then be provided that demonstrates that the controls are functioning. 

Rarely is there a formal confirmation that the person responsible for the control actually has the authority to accept the associated risk.

Risk acceptance can be split into two parts:

1. First, is the Risk Appetite appropriate for this risk? It may well be that the entities Risk Appetite is too caution for this type of risk, and therefore the reduction of the risk to tolerable levels will be too expensive and result in a situation of "over-control". 
2. The second factor is the authority of the person accepting the risk. While companies generally have Delegations of Financial Authority (DFAs), rarely is there a formal Delegation of Risk Authority (DRA). 

To put that into a concrete example, a manager may have a financial delegation of up to $/€/£10,000. That is the level of expenditure that has been determined to be appropriate for that level or individual, without the need for additional authority. The next level up may have a delegation of $/€/£50,000. Finally, for major decisions, a Director or Board authority might be required, say for investment or programmes with a value above $/€/£1,000,000.

But how much Risk can a manager accept? 

What is missing from the picture is the Delegated Risk Authority to accept a residual risk position. All risks have an inherent level of risk and potential impact. We implement controls to reduce or manage the risks resulting in our residual or "net" risk position. Yet our residual risk position may not represent a level of risk that is acceptable to the entity within the bounds of the entity's Risk Appetite. 

Where the residual risk is above the acceptable level, either additional controls or mitigation needs to be put in place, or the residual level of risk needs to be "accepted" (which logically would alter the Risk Appetite for that particular risk). 

The question is; who has the authority to accept that residual level of risk?

My recommendation is that companies put in place a Delegation of Risk Acceptance (DRA) that mirrors their Risk Assessment levels. As most companies use, for better or worse, a Likelihood x Impact grid, that provides us with an example for the Delegation of Risk Acceptance.

When a ‘risk’ is accepted, this indicated that there is agreement that no additional actions or controls will be put in place to further reduce either the impact or the likelihood of the risk.

If, for example, the entity may have assessed the risk of a System Failure as a "High Likelihood / High Impact" pre-remediation of any kind. Controls in the form of effective governance over IT systems may have brought the assessed residual level of risk down the "Medium/Medium". However, the Risk Appetite may have been stated by the Board to be "Medium (Likelihood)/ Low (Impact)".

In this case, there is a disconnect between the residual risk position and the Risk Appetite, and either the residual risk must be "accepted" or additional control must be put in place.

The "solution" is the Delegations of Risk Acceptance.

For each risk (as per the Risk Appetite and/or grid) there should be an identified level of authority to accept a residual risk position. For example, a residual risk level of High/High should only be "accepted" by the Board, while a Low/Low residual risk position may be "accepted" by a manager.

In this case, the DRA may state that residual risk positions that are "Medium" (in likelihood or impact) require acceptance at the Cxx level. In which case, for this example, the CIO should be required to "accept" the residual "Medium / Medium" position, based on an assessment of the cost and effort to bring the residual risk to the Risk Appetite level of "Medium / Low".

The key to the Delegation of Risk Acceptance is that it is linked to the difference between the actual residual risk scoring and the Risk Appetite. Where there is no difference, and the residual risks score equals the Risk Appetite, there is no need to "accept" the risk.

Has this been implemented?

Yes, though with mixed success. As with all issues of Risk Management, the quality of Board, Director and Senior Management buy-in is critical. Communication is required, and an understanding of the risk and control environment, both internal and external.

When used effectively, the DRA can ensure that risk acceptance is being taken at the right levels, or additional investment is authorised to bring the residual risk situation into line with the Risk Appetite. I have seen this accomplished, and the risk environment has been demonstrably improved.

Likewise this provides Internal Audit with an effective tool to communicate and encourage the implementation of effective controls. On the one hand, IA "empowers" the auditee to perform their risk assessment and to then gain the required investment or reallocation of resources to resolve the audit issue, or management with sufficient DRA is then able to confirm that the risk as identified by IA has been accepted at an appropriate level.