This is the firm s risk threshold. The firm must be aware of the risks and their potential severity. A risk audit should be conducted to understand the different threats facing the firm. Confidence limits or boundaries need to be placed on the estimates of risk factors. These limits are designed to make managers aware that corrective action may have to be undertaken as losses reach some critical point.
Firms have two possible routes to managing excess risk in their operations.
One is changes to their operations, and the second is to use financial markets to modify their exposures. When building a risk management strategy, the firm will start by looking at its operational management to see if it can find ways to reduce the risks it is taking. In doing so, it will look both at its industry and its competitors and at how it manages its own products and services. Firms should be aware of risks from its own history. This raises the awareness of the risk problem.