A Paisley White Paper

Fundamentals of GRC: Mastering Risk Assessment

Prepared by:
Bruce McCuaig Chief Risk Officer and Principal Consultant

Fundamentals of GRC: Mastering Risk Assessment

Fundamentals of GRC: Mastering Risk Assessment

Table of Contents Introduction Risk AssessmentsThe Basics The Emergence of RiskBased Approaches Use a Risk-Focused Approach Adopt a Common Categorization of Risk Types Parse the Risk Jumble Scenario Analysis Use a Risk Table Monitor Risks Increase Self Assessment Achieve Risk Convergence Bringing it all Together Leveraging Technology for Risk Convergence About Paisley 2 2

INTRODUCTION
The recent news headlines related to subprime mortgage crisis, rogue

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traders, and corporate fraud have highlighted that despite investment in risk assessment and risk management disciplines, significant risk failures persist. While isolated incidents of one-time governance failures are bound to occur, long-term systemic failures are more than just an isolated anomaly. The failures may be the result of a clutter of risk information caused by many risk assessments from many perspectives. The process of organizing these risk assessments to provide organizations with a more holistic view of enterprise risk is fundamental to mastering risk assessments. This whitepaper explores approaches to risk assessment, offers some best practices for conducting risk assessments and provides practical guidance on mastering this business process.

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RISK ASSESSMENTS THE

BASICS

Risk assessments fall into the overall discipline of risk management. For most organizations, risk management is an evolving discipline that is at disparate maturity levels across organizational disciplines such as internal audit, business operations, IT and finance. Risk is defined as the uncertainty of an event occurring that could have an impact on the achievement of objectives. The definition of risk assessment then follows as the identification, evaluation, and estimation of the levels of risks involved in a situation, their comparison against benchmarks or standards, and determination of an acceptable level of risk. A risk assessment should answer the following five questions: 1. 2. 3. 4. 5. What can go wrong? How can it go wrong? What is the potential harm? What can be done about it? How can we stop it from happening again?

Fundamentals of GRC: Mastering Risk Assessment

THE

EMERGENCE OF RISK-BASED APPROACHES

Increasingly, risk assessments are being conducted by many groups within an organization to fulfill a variety of business and regulatory requirements. Often, groups within the same organization rely on the guidance of different professional organizations to provide a framework for conducting risk assessments. As these professional organizations offer disparate approaches to risk assessment, they add to the jumble of risk information. Examples of the varying approaches to risk assessment include:

To minimize the confusion of varying risk information, risks assessment efforts need to converge

The PCAOB Auditing Standard No. 5 (AS5) has been issued as a riskbased approach to auditing internal control over financial reporting

COSO produced, Enterprise Risk Management Integrated Framework for use in assessing a wide range of business risks

The Institute of Internal Auditors has charged chief audit executives with developing risk-based plans to determine the priorities of the internal audit activity, consistent with the organizations goals

Standard & Poors recently proposed scoring managements enterprise risk assessment practices as part of the credit rating process as well as have proposed the criteria they plan to use to do so

To minimize the confusion of varying risk information, risks assessment efforts need to converge. Risk convergence, the ability to look across the organization and to understand all risk information from a single perspective, is essential to be able to understand and organize the different types of risk information in order to promote the understanding and analysis that will add value to the organization. The following best practice approaches will help an organization master risk assessment and minimize disjointed risk information: 1. Use a risk-focused approach

2. Adopt a common categorization of risk types 3. 4. Parse the risk jumble Perform scenario analysis

Fundamentals of GRC: Mastering Risk Assessment

5. 6.

Use a risk table Monitor risks

7. Increase self assessment 8. Achieve risk convergence

USE

A RISK-FOCUSED APPROACH

Many organizations struggle to find the proper balance between a risk-focused vs. control-focused approach to risk assessments. Risk management, must focus on constant, rigorous risk identification and assessment. Controls must be precise and carefully designed not to distract attention from running the business. Controls must provide essential and useful information, and they must add value rather than exist for their own sake. For most organizations, there is a bias towards control-focused risk assessments. The primary driver of this struggle is complying with regulations, such as Sarbanes Oxley, that originally drove the increased need for risk assessments. Even revised guidance on financial controls management, such as the PCAOBs Audit Standard No. 5 takes a very control centric view. This control bias can be highlighted by contrasting AS5 and Australia/New Zealand Standard 4360. AS5, published in 2007, follows a controls approach and is intended to help auditors identify and assess controls that address the risk of misstatement to financial statement assertions. Described as a risk-based approach, AS5 is actually directed at managing financial controls. AS/NZS 4360, originally developed in 1995 and one of the worlds most critically acclaimed risk management frameworks, is simple and direct and provides a basis for identifying and assessing business risks. A simple word count of the instances of the words risk and control appearing in the two standards makes a strong point. What stands out in Exhibit 1 is the relative use of the terms risk and control by the respective standards. What is less apparent, and possibly even more significant than the difference in frequency of the use of the two words, is the fact that these two standards both look at risk and control differently. When AS5 refers to risk, it is primarily referring to the risk of a missing or broken control. When AS/NZS refers to control, it refers to one of several risk responses (reject, accept, transfer or mitigate the risk.) As a result, risk assessment teams find themselves

AS5 and AS/NZS 4360 look at risk and control differently

Fundamentals of GRC: Mastering Risk Assessment

WORD COUNT COMPARISON

A control-based approach has a bias toward increasing controls until the assessor achieves a subjectively determined level of control effectiveness
Because it seeks to identify missing or ineffective controls and strengthen them, a control-based approach has a bias toward increasing controls until the assessor achieves a subjectively determined level of control effectiveness. Control-based approaches gather and assess vastly more information about controls than about the specific risk events the controls were designed to mitigate. In fact, taken to an extreme, control-based approaches completely lose sight of the business risk they were designed to mitigate. The end result of control-based approaches can become ensuring the continued existence of effective controls, even if the effective controls are no longer relevant to the risks they were designed to mitigate. Risk-based approaches can be described as those that provide a ratio of at least 2:1 of risks to controls and generally have the opposite bias; producing significant amounts of information about risk events, their type, frequency, level, impact and root cause. With the capture of proper risk information, risk-based approaches provide management a better perspective on significance and likelihood of risk events and enable management to prioritize the materiality of mitigating controls. One of the major reasons for the ineffective execution of risk assessments is the significant focus on controls. The control-based approach is used to identify and assess controls, or more specifically the risk of missing or broken controls; the risk-based approach is used to identify and assess risk events, or risks that could impact the achievement of business objectives. Risk assessments are much more effective when using a true risk-based approach. accumulating vast amounts of information about risk from both risk- and control-focused perspectives. Many different risk management groups use the same terminology with completely different meaning.

RISK Risk Standard ANZ/NZS 4360 Audit Standard PCAOB AS5

CONTROL

307

168
Exhibit 1

635

Fundamentals of GRC: Mastering Risk Assessment

ADOPT

A COMMON CATEGORIZATION OF RISK TYPES

To assist in the discipline of risk assessment, it is important to have a common taxonomy and categorization of risk types. The risk management community has provided numerous risk models to categorize risks into types for reporting and analysis purposes. For example, in their recent proposal to evaluate managements enterprise risk management practices, Standard & Poors suggested a list of possible risk types, shown in Exhibit 2.

ENVIRONMENTAL

FINANCIAL
RISKS Capital availability Credit counterparty Financial market risk Inflation Interest rates Liquidity

SUPPLY
RISKS Commodity prices Supply chain

MANAGEMENT
RISKS Corporate governance Data security Employee health and safety Intellectual property Labor disputes Labor skills shortage M&A/restructuring Managing complexity Outsourcing problems Project management Reputation Technology failure

With a library of common sets of risk categories, risk assessment practitioners are better able to identify the organization's risks

RISKS Business continuity Business market environment Environmental Liability lawsuits Natural disasters/ weather Pandemic Physical damage Political risk Regulatory/legislative Terrorism

Exhibit 2

With a library of common sets of risk categories, risk assessment practitioners are better able to identify the organization's risks and can pull together risk information in a concise profile that helps users understand and monitor identified exposures.

PARSE

THE RISK JUMBLE

Risk information must be organized to be understood and managed. In the jumble of risk information that is currently being gathered, some of the information is about controls or more accurately missing or broken controls, some of it is about risk events (the events the controls were designed to mitigate) and some of the information describes the primary or secondary consequences of the risk events if they occur. The result is a mass of information that is described as risk, but it is not all risk (See Exhibit 3).

Fundamentals of GRC: Mastering Risk Assessment

Exhibit 3

To assist in sorting through this information, it is recommended to parse the information into a simple model of:

Root cause Risk Consequence Downstream effect

Exhibit 4 illustrates how risk information can be categorized as root cause, risk event, consequence and downstream effect. In this example, the broken shoelace is the root cause, falling is a risk, a sprained wrist is the consequence and the downstream effect is medical bills. In business it is important to delineate what is the root cause and what is the risk. At first glance, many identify the broken shoelace as the risk. However, the risk is the adverse outcome of the root cause, not the root cause itself.

Risk information can be categorized as root cause, risk event, consequence and downstream effect

Exhibit 4

Fundamentals of GRC: Mastering Risk Assessment

Effective risk assessments forces one to ask, What could go wrong in the future?

There are several root causes that can create the risk Trip and fall. When conducting a risk assessment one should not assume a static relationship between a root cause and a risk event. This may lead to overlooking other root causes and failing to address the risk.

SCENARIO

ANALYSIS

The discipline of scenario analysis is critical to effective risk assessments because it forces one to ask, What could go wrong in the future? Scenario analysis is the process of analyzing a number of possible future events and focuses attention on all possible outcomes of an event occurring and the associated impacts. Proper scenario analysis improves decision-making by allowing management to more completely consider various outcomes and their implications to an organization. For example, in looking at the scenario of fraudulent trades occurring, the following questions need to be evaluated: 1. Where does trading activity take place? 2. What kinds of trading takes place? 3. What are all the ways unauthorized trading could take place? 4. 5. 6. 7. 8. 9. How up to date is our information? Have we involved everyone with relevant knowledge in risk identification? Have we involved everyone with relevant knowledge in control assessment? What would tell us if, in fact, unauthorized trades are occurring? How often do we formally analyze this scenario? What issues have we identified in the past?

10. What losses have our industry competitors experienced? 11. How could trades be hidden? To avoid scenario analysis becoming a time consuming and burdensome activity, management should focus on those risks that have been identified as the most material to the strategy of the business and that have the highest significance or likelihood of occurring.

USE

A RISK TABLE

Risks and the corresponding risk assessments can be evaluated using either a quantitative or a qualitative approach. Quantitative assessments use actual dollar amounts to provide a financially-based risk value. Qualitative assessments use

Fundamentals of GRC: Mastering Risk Assessment

scoring methods and the experience of employees and consultants to arrive at a risk score. Since determining an actual dollar value of risk is often times a very resource intensive activity, the qualitative risk assessment approach is used as a best practice by most risk assessment groups. Although termed a qualitative approach, this method typically involves assigning some numerical value that can be used to stack rank or come up with some relative ratings on the assessment of risks. To assist with the qualitative risk assessments utilize an established risk table. There are several commonly used published risk tables, some more complex than others. One of the most frequently used risk tables is the AS/NZS 4360, shown in Exhibit 5.

Rejecting risk is the head-in-the-sand approach

Exhibit 5

Once the risk assessments are scored using a risk table, they should be sorted from highest to lowest. This allows organizations to address the highest risks first. Once identified, there are essentially four ways to deal with each risk: Reject the risk: Rejecting risk is the head-in-the-sand approach. Some managers tend to ignore difficult challenges with the hope that they will simply disappear. This approach will rarely result in a successful defense against the risk event occurring.

Fundamentals of GRC: Mastering Risk Assessment

Accept the risk: A common action to take is to accept the stated risk. For example, if the controls necessary to eliminate or mitigate key vulnerabilities are a greater financial burden to an organization than the actual risk impact, then its probably a good idea to use the budget dollars in other areas. Transfer the risk: An alternative to accepting a higher than reasonable risk when the cost of controls is too high is to purchase insurance to lower the business impact of an incident. This is a common risk management step. Mitigate the risk: Risk mitigation typically focuses on managing the areas where the organization is most vulnerable. Risk mitigation involves the identification and management of risk mitigating controls.

MONITOR

RISKS

A best practice in mastering risk assessments is to establish standard metrics for the consequences and outcomes that will drive business decisions. Common metrics are classified as key performance indicators (KPI) and key risk indicators (KRI). A KPI is part of a measurable objective and helps an organization measure progress towards goals, especially toward difficult to quantify knowledgebased processes. KPIs are made up of a direction, benchmark, target and time frame. A KRI measures how risky an activity is. It differs from a KPI in that the KPI is meant as a measure of how well something is being done. A KRI is an indicator of the possibility of a future adverse impact. The idea behind the KRI is to provide a set of agreed indicators, which can range from the simple, such as staff turnover, to the more sophisticated, such as the a complex

Establish standard metrics for the consequences

calculation for measuring operational performance. The behavior of KRIs should signal how well or how badly a firm is managing potentially costly operational hazards such as fraud, legal risk, technology failure and trade settlement errors Knowledge of consequences is essential for risk management decisions. The nature and magnitude of the consequence will drive business decisions. Established KPIs and KRIs place some established metrics on measuring these consequences and outcomes.

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Fundamentals of GRC: Mastering Risk Assessment

INCREASE

SELF ASSESSMENT

With the large universe of risks that must be assessed across an organization, companies must embrace the discipline of risk self assessment to delegate the workload to those closest to the risks. Risk self assessment is a tool for acquiring information about business process risks, while empowering the process owners to take responsibility for identifying and mitigating those risks. Using risk self assessment drives the responsibility and accountability of risk management to process owners by reinforcing their responsibility and accountability for the risk areas that they own. Companies embracing risk self-assessment often view it as a cost-effective technique for establishing touch points with the right people, enabling management to communicate as well as educate. An effective risk self-assessment program reports risk assertions from process owners upward in the organization and identifies matters requiring follow-up and possible disclosure.

Risk self assessment drives the responsibility and accountability of risk management to process owners

ACHIEVE

RISK CONVERGENCE

Risk convergence is the integration of discrete risk assessment information into a unified framework in order to dramatically:

Streamline processes Increase assurance reliability Increase information quantity/quality Decrease operational cost Contribute directly to better business performance

Risk-based approaches to management hold significant promise. If risks are understood in terms of cause/effect relationships, governance failures and losses should be prevented. If variance in expected business or process performance is viewed from a risk perspective as unmanaged risks, then business performance should improve or at least become less volatile. Risk assessment is the foundation of risk management. Organizing the information produced through risk assessment will allow risk convergence to fulfill its potential.

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Fundamentals of GRC: Mastering Risk Assessment

BRINGING

IT ALL TOGETHER

LEVERAGING

TECHNOLOGY FOR

RISK CONVERGENCE
Leading organizations are leveraging technology solutions to support their risk convergence efforts. Paisley offers a more effective, proven approach to optimizing the convergence of risk assessment groups. Paisleys GRC solutions offer a comprehensive audit, financial controls management, risk management, IT governance and compliance software solution purpose-built to address integrated risk convergence requirements. By eliminating information silos, redundant data entry and taking a unique holistic approach to regulatory challenges, Paisleys GRC solutions provide greater efficiency, improve collaboration and reduce the time and resource costs associated with governance, risk and compliance processes. Paisleys GRC solutions enable organizations to break down the walls between audit, risk and compliance groups and provide expanded value as organizations deploy the software across the enterprise. Paisleys GRC solutions provide unique profiles for each risk assessment group, a central data repository and common functionality for risk assessment, reporting and issue tracking across all disciplines. As a complete solution, Paisleys GRC solutions provide a common point of entry for audit, risk management and compliance process owners. With a single data model that is shared by internal audit, risk management and compliance teams, Paisleys GRC solutions enable organizations to consistently share definitions and terms, organizational reporting structures, and relationships between controls and the associated audit results. This approach minimizes data entry, improves accuracy and enhances collaboration, efficiency and consistency.

Paisleys GRC solutions provide a common point of entry for audit, risk management and compliance process owners

ABOUT PAISLEY
Paisley is an industry leading software vendor that provides solutions for governance, risk and compliance (GRC) including financial controls management, internal audit, operational risk management, compliance, IT governance, and enterprise risk management. For more than a decade, Paisley has delivered superior software and services to both large enterprise and mid-market organizations. Governance, risk and compliance software has always been and continues to be the company's focus.

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Fundamentals of GRC: Mastering Risk Assessment

Leveraging industry best practices, standards based technology, and a choice

For more information, call 320.286.5870, email info@[Link] or visit [Link]

of software platforms and deployment options, Paisley customers are empowered to improve the accuracy, consistency and efficiency associated with internal audit, financial controls management, enterprise risk management, operational risk management, IT governance, and compliance initiatives. Developed for companies of every size and across multiple industries, Paisleys solutions enable organizations to streamline governance, risk, and compliance processes, reduce costs of compliance, manage and mitigate risks, and provide visibility, oversight and assurance. For more information, call 320.286.5870, email info@[Link] or visit [Link].

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