Inherent Risk vs Residual Risk: What You Need to Know

In enterprise risk management, two crucial terms often surface - inherent and residual risks. These concepts are fundamental to assessing, analysing, and mitigating risks in any organisation.

They help security teams, businesses, and regulatory bodies navigate potential threats while safeguarding sensitive data and ensuring business continuity.

But what exactly is the difference between inherent and residual risk, and why are both important? Let us break it down in simple terms to give you a clear understanding.

Key Differences:

• In simple terms, inherent risk is the risk present in a process or activity before any security controls or mitigation measures are applied.

• On the other hand, residual risk is the risk that remains after implementing controls and mitigation measures.

Why is Inherent and Residual Risk Important?

According to the UK Cybersecurity Breaches Survey 2024, 31% of businesses conducted cybersecurity risk assessments in the past year, rising to 63% for medium-sized businesses and 72% for large businesses.

Therefore, understanding and evaluating inherent and residual risks are key to an effective risk management strategy. Here is why organisations should focus on these two terms:

• Improved Risk Awareness: Organisations gain insight into the nature and scope of risks.

• Compliance with Regulatory Requirements: Proper risk analysis and assessment ensure legal and industry standards alignment.

• Effective Resource Allocation: Companies can prioritise efforts to mitigate the most significant risks.

• Enhanced Security Measures: Security teams can design better defences with third-party risk management to protect sensitive data and business processes by identifying existing of risk levels.

What Is Inherent Risk?

Inherent risk represents the level of risk present in a business process, operation, or environment before any controls or mitigation measures are implemented. It’s the “raw” risk that exists when no safeguards are in place to reduce the likelihood or potential impact of a threat. Some of the characteristics include:

1. Absence of Controls: It assumes no controls, measures, or defences are present to counteract threats.

2. Potential Impact: The impact of inherent risks can vary from minor disruptions to significant financial or reputational damage.

3. Example: In the supply chain, third-party risk management vendors introduce risks due to their less direct oversight.

What Is Residual Risk?

Residual risk refers to the level of risk that remains after an organisation has implemented security controls to mitigate inherent risks. It considers the effectiveness of existing security measures and additional actions taken to reduce risk. Some of the characteristics include:

1. Security Controls in Place: Residual risk reflects risks that persist despite efforts to address them.

2. Acceptable Levels: Organisations aim to bring residual risks to an acceptable level in alignment with risk tolerance.

3. Example: Businesses might still face residual risks from sophisticated cyberattacks after implementing robust next-gen firewalls and access controls.

Inherent Risk vs Residual Risk: Key Differences Explained

Here is a simplified point-by-point comparison of the difference between inherent risk and residual risk:

Presence of Controls

Inherent Risks: Assumes no controls exist, and the risk is evaluated in its raw state.

Residual Risks: Considers the effectiveness of implemented controls and measures.

Purpose

Inherent Risks: Serves as a baseline to understand the original level of risk.

Residual Risk: Helps to evaluate whether the current level of risk is acceptable or if additional actions are needed.

Risk Level

Inherent Risks: Typically, higher because no defences are in place to mitigate it.

Residual Risks: Usually lower as security controls have been applied to reduce the risk.

Focus

Inherent Risks: Focuses on identifying and analysing risks in their natural state to prepare for mitigation.

Residual Risks: Focuses on ensuring the remaining risk aligns with the organisation’s risk tolerance.

Action

Inherent Risks: Requires an assessment to determine the necessary risk management strategies.

Residual Risks: This may require additional mitigation strategies or adjustments to ensure alignment with acceptable risk levels.

Formula to Calculate Inherent Risk

The formula for calculating inherent risk evaluates the potential impact and likelihood of a risk event occurring without any security controls in place:

Inherent Risk = Likelihood of Risk Event × Potential Impact

Explanation:

Likelihood of Risk Event: The probability that the risk will occur (often measured on a scale of 1 to 5 or as a percentage).

Potential Impact: The severity of consequences if the risk materialises (measured similarly to likelihood).

Example:

If the likelihood of a data breach is 4 (on a scale of 1 to 5) and the potential financial impact is 5, the inherent risk score would be:

Inherent Risk=4×5=20

Formula to Calculate Residual Risk

Residual risk considers the impact of existing controls and how much risk remains after mitigation measures have been implemented:

Residual Risk = (Likelihood of Risk Event × Potential Impact) × (1 − Effectiveness of Controls)

Explanation:

Likelihood of Risk Event: The probability that the risk will occur.

Potential Impact: The severity of the consequences.

Effectiveness of Controls: A percentage or decimal representing how well the controls reduce the inherent risk.

Example:

If the likelihood of a data breach is 4 (on a scale of 1 to 5), the potential financial impact is 5, and the effectiveness of controls is 80% (or 0.8), then the residual risk score would be:

Residual Risk = (4×5) × (1−0.8)

Residual Risk = 20 × 0.2 = 4

Relationship Between Inherent Risk and Residual Risk

Residual risks are always less than or equal to inherent risks because they reflect the risk remaining after security controls have been applied. It can be expressed as:

Residual Risk= Inherent Risk × (1−Effectiveness of Controls)

This formula emphasises the importance of a robust risk management strategy in lowering the current risk level.

The Role of a Risk Assessment

A comprehensive risk assessment process involves identifying and analysing potential threats, vulnerabilities, and the impacts they may have.

Steps in the Risk Assessment Process

• Identify Risks: Look at internal and external risk factors affecting operations.

• Assessing Inherent Risk: Determine the risk levels in the absence of security controls.

• Implement Controls: Introduce measures like firewalls, policies, or employee training.

• Calculate Residual Risks: Evaluate the remaining risks after security controls are applied.

• Compare to Risk Tolerance: Ensure residual risks align with the organisation's acceptable levels.

How to Mitigate Inherent and Residual Risks

Reducing inherent risk and residual risk requires a mix of proactive and reactive strategies. Here are some steps to consider:

1. Strengthening Internal Controls: Effective internal controls are the backbone of risk management.

2. Implementing Security Controls: From firewalls to encryption, security controls reduce vulnerabilities and the likelihood of threats. They also help secure sensitive data and mitigate residual risks.

3. Conducting Risk Assessments Regularly: Ongoing risk assessments help monitor the effectiveness of existing measures and uncover new potential risks.

4. Adding New Controls When Necessary: When the current risk levels exceed the organisation’s tolerance, introducing additional controls is essential to mitigate risks further.

5. Collaborating with Third-Party Vendors: Strong third-party risk management practices are necessary to address risks introduced by external partners. This includes vetting vendors and ensuring they comply with industry standards.

Summary

Effectively managing risks requires organisations to understand and address both inherent risks and residual risks. By assessing, analysing, and continually improving risk controls, businesses can minimise threats and ensure long-term success.

Through regular risk assessments, tailored risk mitigation strategies, and collaboration with security teams and third-party vendors like Aztech, companies can bring risks to an acceptable level while maintaining compliance and protecting their most valuable assets.

Discover how Aztech can help you mitigate risks and develop a risk management strategy. Contact us today to explore what we can do for you.