What Is Risk Modeling?

Malcolm Tatum

Risk modeling is a strategy that focuses on qualifying and quantifying the amount of risk associated with a given activity, transaction, or project. The goal of the modeling effort is to accurately identify risks associated with the venture, identify the degree of potential associated with each of those risks, and how each of those risk factors could ultimately affect the outcome of the activity. Engaging in risk modeling can help businesses and investors determine if the overall level of risk associated with an activity can be justified by the potential rewards that are likely to result.

Businessman giving a thumbs-up
Businessman giving a thumbs-up

The exact nature of risk modeling will vary, based on the situation under consideration, although the basic process will remain the same. Effort must be made to identify any possible risk factor associated with the activity, no matter how great or small that risk may be. Identifying potential risks often requires drawing on historical data related to similar activities as well as considering the unique characteristics of the activity that is currently under scrutiny. From there, taking the time to qualify each risk in terms of the likelihood of occurrence will provide additional data that makes it easier to prioritize all the potential liabilities involved. After identifying and prioritizing the risks, the resulting risk model can be considered in light of the possible rewards that could result from proceeding with the activity, making it easier to decide whether or not the activity is worth the time, effort, and resources necessary.

Different considerations will be involved in the risk modeling, depending on the nature of the activity. A risk model as it relates to extending credit to a customer will include any slow pays or defaults on debt that are associated with that client. Investors will want to include data that addresses past performance of securities currently under consideration, along with current status in the market and the potential for future performance. Even with something like buying a piece of real estate, the buyer will want to think in terms of what is happening with property values in the neighborhood and what is most likely to happen over the next several years before assuming the risk of owing that property is well below the rewards.

The key to effective risk modeling is the inclusion of all relevant factors that could impact how much benefit is received from proceeding with the activity. By taking the time to identify what could go wrong and reduce those benefits, and then looking closely at each one to determine the level of possibility associated with those risks, it is much easier to make an informed decision of how to proceed. While the time invested in risk modeling can sometimes be significant, the use of this tool to avoid bad deals that could create serious financial damage more than justifies that time and effort.

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