When it comes to effective third-party risk management, the proper identification, assessment and treatment of risks are essential. To accomplish this, it’s essential to understand two fundamental concepts: inherent risk and residual risk. Of the two risk types, residual risk, tends to be more misunderstood and even confusing for many third-party risk practitioners.
This blog will help you differentiate between inherent and residual risks and recognize how they should be applied to your third-party risk management processes. Additionally, we’ll highlight the importance of residual risk and how to integrate it into your organization's ability to understand and manage vendor risks.
Inherent Risk vs. Residual Risk
Before we explain residual vendor risk, it's important to understand what comes before – which is inherent vendor risk. It’s necessary to understand that inherent risk is the measurement of risk before any controls (rules, tools, processes and procedures) are applied to reduce or mitigate the risk. The idea of inherent risk is that the product or service naturally contains risks.
An inherent risk rating should reflect the types and amounts of present risks. For example, if your vendor provides you with electronic data storage services, there are certain risks embedded in that data storage activity including data loss, theft or misuse.
Every vendor engagement should be assigned an inherent risk rating or score. The inherent risk rating (or score) determines what actions are necessary to manage the vendor risks throughout the relationship. For example, due diligence requirements should be determined by inherent risk. The higher the risk, the more extensive the due diligence must be. Inherent risk also determines the frequency of ongoing monitoring activities like periodic risk assessments and performance review schedules.
How to Calculate Residual Risk
Once the risks are identified, specific controls can be applied to treat the risk or, in other words, lessen the likelihood, occurrence, severity or impact of those risks. This process results in something called residual vendor risk.
Here’s a helpful calculation:
During the calculation of residual vendor risk, the risk is examined in consideration of the controls. As a reminder, this calculation does NOT remove or reduce the inherent risk. It simply indicates whether the applied controls are adequate. Your residual risk score can help you determine how comfortable the organization should be in moving forward with any particular vendor.
It’s imperative to understand that the residual calculation or score should never replace an inherent risk rating. When it comes to determining how your organization will manage the vendor, you must always align your third-party risk management activities with the inherent risk rating.
4 Reasons to Calculate Residual Vendor Risk
Now that you understand how residual vendor risk is calculated, you might wonder why or if it really matters. After all, if third-party risk management activities are driven by inherent risk, where does residual risk come into play? There is no doubt that residual risk is an integral part of third-party risk management.
Calculating the residual vendor risk can help accomplish the following:
- Check inherent risk – If the residual risk is higher than the inherent risk, you've made a mistake in your calculation. The residual risk will always be equal to or lower than the inherent risk.
- Identify whether the control measures applied are sufficient – Residual risk can help determine if more or different controls are necessary to treat the risk.
- Verify your organization's risk appetite – Your organization will have to determine whether the residual risks of vendors are acceptable.
- Keep an eye on unmitigated risks – Unchanged residual risk should prompt your organization to keep a close eye on any vendor risk that couldn't be mitigated successfully.
Next Steps – When Controls Aren't Enough
Suppose that after calculating the residual risk you still have concerns regarding the effectiveness of the vendor's controls. In that case, here are a few options:
- Avoid the risk: If the risks are too high and the benefits are too few, your organization may decide to avoid the vendor relationship altogether.
- Transfer the risk: It may be possible to transfer the financial liability to your third party through carefully written contract provisions or to an insurer through the purchase of an insurance policy. In this situation, you’re only moving financial liability. Your organization is always responsible for the risks.
- Apply different or additional mitigating controls: Your organization may decide that additional measures are necessary to bring the risk within an acceptable limit. Additional controls could include enhanced contract language, improved information security protocols, independent third-party audits, etc.
- Accept the risk: In some cases, risk can’t be mitigated. Still, the benefits of the vendor relationship are worth the potential risks. In these instances, it’s vital to have a formalized risk acceptance process that includes a documented evaluation of the risks and the rationale for accepting them. It’s also essential to make sure that any decisions to accept risk on behalf of the organization are approved at the appropriate management level.
Although the inherent risk is the basis of many third-party risk management activities, don't assume residual risk serves no purpose. By understanding your vendor's residual risk, you'll be better prepared to take action and make decisions to protect your organization against avoidable vendor risks.