Risk likelihood and magnitude

Risk likelihood and magnitude are best demonstrated using a risk map, sometimes referred to as a risk matrix. Risk maps can be produced in many formats. Whatever format is used for a risk map, it is a very valuable tool for the risk management practitioner. The basic style of risk map plots the likelihood of an event against the magnitude or impact should the event materialize.

Figure 1.1 is an illustration of a simple risk matrix, sometimes referred to as a heat map. This is a commonly used method of illustrating risk likelihood and the magnitude (or severity) of the event should the risk materialize. The use of the risk matrix to illustrate risk likelihood and magnitude is a fundamentally important risk management tool. The risk matrix can be used to plot the nature of individual risks, so that the organization can decide whether the risk is acceptable and within the risk appetite and/or risk capacity of the organization.

Throughout this book, a standard format for presenting a risk map has been adopted. The horizontal axis is used to represent likelihood. The term likelihood is used rather than frequency, because the word frequency implies that events will definitely occur and the map is registering how often these events take place. Likelihood is a broader word that includes frequency, but also refers to the chances of an unlikely event happening. However, in risk management literature, the word probability will often be used to describe the likelihood of a risk materializing.

Figure 1.1 Risk likelihood and magnitude

The vertical axis is used to indicate magnitude in Figure 1.1. The word magnitude is used rather than severity, so that the same style of risk map can be used to illustrate hazard, control and opportunity risks. Severity implies that the event is undesirable and is, therefore, related to hazard risks.

Figure 1.1 maps likelihood against the magnitude of an event. However, the more important consideration for risk managers is not the magnitude of the event, but the impact or consequences. For example, a large fire could occur that completely destroys a warehouse of a distribution and logistics company. Although the magnitude of the event may be large, if the company has produced plans to cope with such an event, the impact on the overall business may be much less than would otherwise be anticipated.

The magnitude of an event may be considered to be the inherent level of the event and the impact can be considered to be the risk-managed level. Because the impact (or consequences) of an event is usually more important than its magnitude (or severity), then every risk matrix used in the remainder of this book will plot impact against likelihood, rather than magnitude against likelihood.

The risk matrix will be used throughout this book to provide a visual representation of risks. It can also be used to indicate the likely risk control mechanisms that can be applied. The risk matrix can also be used to record the inherent, current (or residual) and target levels of the risk.

Colour coding is often used on the risk matrix to provide a visual representation of the importance of each risk under consideration. As risks move towards the top right-hand corner of the risk matrix, they become more likely and have a greater impact. Therefore, the risk becomes more important and immediate and effective risk control measures need to be introduced.

As a practical example of risk management in action at strategic level, consider the uncertainties embedded in the merger involving Delta Airlines and Northwest Airlines. This illustrates that organizations take strategic decisions that involve high levels of risk and uncertainty. There will be considerable uncertainties relating to whether all of the benefits outlined below can be delivered in practice.