Risk analysis involves the identification and quantification of events that could trigger losses for an organization. These events could be well outside of the normal issues experienced by a business, such as the possibility of a 100-year flood, an earthquake, or the expropriation of a facility in another country. Once these events have been identified, the risk analysis process is used to estimate the probability of occurrence and the amount of loss associated with each event. This step is intended to locate those events that will have the most serious negative impact on the firm. The results of this analysis can then be incorporated into a risk management process, where a range of risk mitigation actions are formulated. For example, certain activities can be avoided or insurance can be purchased to shift the risk to a third party.
Risk analysis is also used when evaluating whether to make an investment. The process is especially applicable for capital budgeting, where an organization may be committing a large amount of cash to a project. In this situation, it is very cost-effective to work through a detailed risk analysis, thereby giving management a better understanding of the risk of loss associated with a possible investment. When there is clearly a high level of risk, a capital investment must have a correspondingly high rate of return, so that the business is adequately compensated for the level of risk it is undertaking.