ProbabilityA risk is a probability of a future loss. As such, estimating probabilities is required to measure risk. The following are illustrative examples.
A 1% chance that a house in a high risk area will experience a flood within 5 years.
A 20% probability that a high risk investment will lose all of its value within 5 years.
A 30% chance that you will drop out of college without a degree.
A 60% probability that a small business will fail.
A 6% chance that you will not like your new house or neighborhood and feel compelled to move within 5 years.
ImpactImpact is the size of a loss associated with a risk. This can be measured in financial terms or in other ways such as quality of life.
A failed product that will cause $900,000 in losses.
An incomplete college education that is worth approximately $200,000 less than the opportunity costs incurred.
A work related injury that will cause a severe decline in quality of life and reduced lifetime earnings of $1.8 million.
A data center fire estimated to cause $40,000 damage, $900,000 in operational costs and $5.6 million in contractual penalties to customers.
Risk MatrixIn the real world, there are usually different levels of risk impact each with a different probability. For example, a product that completely fails on the market versus one that achieves some sales below target. These levels of risk impact can be modeled with a table of estimates known as a probability-impact matrix.
Continuous EstimatesAdvanced risk management models in industries such as banking and insurance are based on probability distributions that give a probability for every possible impact.
Cost of RiskCost of risk is an estimate of the total cost of a risk or set of risks including the costs of treating risk. This would include all costs associated with risk management such as insurance as well as estimates of future losses due to risk.
Goal: reduce the cost of IT risk by 35% to 1.1 million in 2037.
Risk ReductionIt is possible to estimate how much you have saved by reducing a risk. For example, if land improvements reduce the chance of wild fire related damage at a hotel, the benefits of this project could be estimated in terms of risk reduction.
The land improvements are projected to reduce the chance of a fire at the facility by 14% per year. This is estimated to reduce future risk related losses by $460,000.