Definition: Residual risk, also called inherent risk, is the balance of risk exposure after identifying and acting on all known threats. In other words, it’s the danger that there will be a loss causing threat that isn’t identified and taken into consideration.
What Does Residual Risk Mean?
What is the definition of residual risk? This is that portion of risks which was not eliminated by management actions at first. The process to minimize the impact on the business may still leave the company vulnerable with an exposed risk. This is called inherent risk. This concept not only applies to threats to a business, but also to opportunities.
Companies assess their risk appetite to see what level of risk they are comfortable with taking. Banks, for example, normally follow a conservative path and do not accept risk easy. Start-up companies, on the other hand, are more aggressive in nature and tend to go after riskier opportunities.
After the management identifies how much risk they are willing to take, the team analyzes the opportunity for everything they think could go wrong and cause the company to lose money. It’s impossible for management to identify every single threat for a course of action. There are always unforeseen consequences of taking any action, so there is always an element of risk associated with the unknown. The unknown risk that resides afterward is what we are taking about in this article.
Let’s look at some examples.
Transfer the risk (threat) The company transports high value goods across country. It is not willing to accept the risk in case of damage. The risk response is to take out insurance and reduce the financial impact in case the product is damaged. The company may decide to accept some inherent risk by not insuring the goods in full.
Enhance the risk (opportunity) The company manufactures an item, which is in a race for time to reach the market first. Two test cycles is required to get the green light for delivery. The risk response is to do an in-house test rehearsal; thereby ensuring the option is open to user acceptance on the first test. This way the product can have an early launch. Inherent risk is the gain from the opportunity that is created to reach the market first.
Share the risk (threat or opportunity) The company trades in the commodity markets. Fuel costs can have a huge impact on a specific contract. The risk response is an agreement with the buyer: From the price at time of closing the deal any increase will be shared but also the gains in case the fuel price drops. Residual risk is zero.
Define Residual Risks: Residual risk means the inherent danger in an opportunity that is left over after all other threats have been considered.