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Residual Risk vs. Inherent Risk

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

An important part of identifying and mitigating risk is understanding what risks you can avoid and what risks you must accept. In this lesson, we will discuss the difference between residual and inherent risk, two types of risk good managers must understand.

Understanding Risk

If you ask some people to define risk, you will often hear the answer 'risk is the chance that something bad will happen.' While that is a common answer, it is not entirely accurate when it comes to managerial accounting and business management. A better definition of risk is the exposure to anything that may stop an individual or organization from accomplishing their objectives. The key difference in these two definitions is that risk should not be associated with a negative event, it should be associated with what might stand in the way of an organization and its objectives.

Inherent Risk

A common cliché states, 'no risk, no reward.' This often holds true and can even be more generalized by saying 'no risk, no movement.' In everything we do, there is risk. But, it isn't enough just to know to be on the lookout for risk or to be aware that it exists. To manage risk effectively, it is important to understand different types of risks and how to deal with them.

Inherent risk is the risk that exists in any action, before any precautions are taken. Think about this at the personal level. You can't leave your house without taking the risk of being hurt - by a falling meteor, a texting driver, or a rabid raccoon. Depending on where you live, the likelihood, or the chance that something might happen, will be different, but the risk is always there. That risk is inherent risk.

Mitigating Inherent Risk

Inherent risk can be handled in one of three ways. First, you can accept the risk. This means you continue with whatever action you were undertaking, and accept the inherent risk that comes with the action. This is what we do most of the time. You can also share the risk. This is essentially insurance. When you pay for automobile liability insurance, you are paying a company to share the risk of you causing an accident. If an accident happens, you may still have some costs, but someone else is sharing in the cost - or rather, sharing the risk of having to bear that cost. Finally, you could avoid the action. Since inherent risk is just part of doing something, if you don't do it, you don't have the risk. But, that isn't a very effective strategy when you think of all the things you need to do to live.

Residual Risk

Residual risk is the remaining risk associated with a course of action after precautions are taken. Another personal example will make this clear. When you drive your car, you are taking the risk that you might cause an accident. That is inherent risk - no matter how safe and careful you are, it will always exist. But, you can take precautions to help protect yourself, such as wearing your seatbelt. If you wear your seatbelt, there is still residual risk, but you have decreased the inherent risk of personal injury.

Mitigating Residual Risk

All the same options for mitigating inherent risk are available with residual risk. You can just accept it - i.e. drive with a seatbelt, knowing that if you get in an accident you still risk injury. Often, this is how we deal with residual risk.

You can also share some residual risk. In the auto insurance example, if you know you are a bit of a crazy driver, you may figure out there will be more residual risk, even when precautions are taken. By lowering the deductibles for your insurance or increasing the limits of coverage, you are sharing some of that residual risk. An important note as it relates to sharing residual risk is that you can't share all of it; the more risk you take, the less you can share.

And of course, you can just avoid the residual risk of driving too, simply by not driving. After discussing acceptance and sharing of residual risk, avoiding it might sound like the best option. But with residual risk, you have a fourth choice. You can manage it.

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