A Guide to Contract Risk Management
Written by Julian Canlas
Every contract has its associated risks, and although no risks can ever be 100% eliminated, there are various ways to protect and mitigate against potential risks. This week, will be sharing a simple risk management framework and some best practices in risk mitigation.
What Is Contract Risk?
Contract risks are generally associated with two issues:
- Possibility of losses arising from other parties in the contract being unable to fulfil their obligations or provide compensation.
- Possibility of losses arising from poor contractual performance.
Examples Of Contract Associated Risks:
Liability risks: These refer to risks involving the threat of companies having to bear the consequences of damage, negligence, poor standard conformations, etc.
- Early contract terminations by any party.
- Invalid claims and warranties made by any contractors.
- Possibilities of a breach of contract occurring due to poor contractor performance.
- Unethical behaviour of suppliers or contractors.
Business Continuity Risks: These are potential risks that will impact the way your business operations are run and threaten the sustainability of your business.
Some examples include:
- Poor working relationships with business partners
- Failure by any contractual party in accomplishing objectives
- Decline in brand reputation resulting from poor contractual performance or management.
Financial risks: These are potential risks that will affect your money inflows and outflows.
- Contractors having cash flow issues.
- Inability to receive timely payment.
- Sudden changes in economic climate.
Importance Of Contract Risk Management
Not all contracts can be treated in the same manner. However, managing your risks well limits your exposure to uncertain situations and ensures that you have contingency plans ready when emergencies arise.
Moreover, managing your contract risks is also an important part of the CLM process. It protects your company from dire consequences and helps your company’s bottom line.
Contract Risk Management Framework
Companies generally adopt a 5-step contract risk management framework, which we will explain in further detail. The main steps include:
Step 1: Identifying the risks in your contractual agreements.
Before carrying out risk identification, you need to understand some common risk definitions, including:
- Market & Economic Risks – Risks inherent from exposure to capital markets such as interest rate and foreign exchange risks.
- Credit Risk – Risk resulting from failure to repay a loan or contractors meeting their contractual obligations.
- Systemic Risks – Risk of failure of a financial system such as financial infrastructure of partners, liquidity issues, etc.
- Demographic risks – Risks associated with skilled employees retiring or leaving the company, resulting in skill gaps.
- Operational Risks – Risks that impact the way your company carries out business such as data risk, people risk, cyber risk, etc.
Now that you have a clearer understanding of risk categories, here are some tools to help you in your risk identification process:
- SWOT Analysis – Identification of the strengths, weaknesses, opportunities, and threats associated with the contract agreement.
- Risk Checklists – Helps in pre-identification of every inherent risk available with past experiences and external data support.
- Risk Prompt lists – Helps in identifying various categories of risks as they appear.
- Case Studies
- Risk Taxonomies – A dictionary for all the previously identified risks in your contractual agreements.
- Risk Trigger Questions – A list of situations/events in a particular aspect of the contract that can lead to potential risks.
- Risk Focused Process Analysis – Constructing flow charts for every process in the contractual agreement and analyzing the points where risks might occur.
With these tools to aid you, some useful risk identification techniques include:
- Brainstorming sessions and working groups
- Independent group analysis
- Surveys and interviews
- Gap analysis
Step 2: Conducting risk assessments.
Risk identification is the most tedious step in the process and should be as detailed and granular as possible. After risk identification, risk assessment helps in identifying and prioritizing which risks require more attention and resources to mitigate.
Some considerations for risk assessments include:
- Company’s risk register – Central document detailing all risks faced by an organization. Some of your contractual risks may already be documented in the risk register, and there is already an existing risk mitigation plan in place.
- Risk profile – Summary of the company’s identified, described and quantified risks with reference to the contractual agreement.
- Risk appetite – What is your company’s risk tolerance and capacity towards taking on additional risks?
- Upside risks – Is there any reason for your company to accept additional exposure to negative outcomes from this contractual agreement?
- Downside risks – These risks need to be consistent with the potential upside risks incurred from the contract.
- Risk measures – Does your company adopt a deterministic (factor & scenario sensitivity analysis) or probabilistic/statistical approach towards measuring risks?
- Unquantifiable risks
Step 3: Choosing the right risk management responses.
After your risk assessment, it is time to determine appropriate risk management responses to protect your business against the potential risks and consequences. Here are the 4 basic responses in contract risk management:
- Reduce – Involves taking active steps to limit the impact of a risk occurring, such as through diversification of suppliers or the creation of more robust systems and processes.
- Remove – Involves taking action to completely remove the risk triggers.
- Transfer – Involves non-capital market (purchasing business insurance) and capital market risk transfers such as turning risk exposure into investments.
- Active management – Usually adopted only when the severity of the risk is small, probability of occurrence is unlikely, or if the cost of removing the risk is greater than your risk exposure.
Step 4: Constantly monitor and evaluate risk responses.
Once your risk responses have been implemented, you need specific monitoring practices in place to gauge the effectiveness of your responses before making modifications. Here are some continuous considerations to look out for in this stage:
- Audits on:
- Risk identification and communication methods
- Risk assessment methods
- Choices and effectiveness of risk responses
- Investigations of any prior risk management failures
- Adequate documentation of:
- Risk registers
- Risk management processes and reasoning
- Decisions taken with specific reasons
- Incident logs with information on all risk management failures
- All general issues
- Internal communication involving risk management strategies and measures to be taken
- External communication with other contractual parties involved
Step 5: Modify existing risk responses.
Here are some best practices to consider:
- Set proper and stringent contract review processes.
The more stringent and rigorous your contract review processes are, the lesser the probability of causing breaches and disputes throughout the partnership.
Being consistent in your usage of well-prepared agreements and contractual provisions will help in developing clauses smoothly enforcing your contracts. The more well prepared your agreements are, the lower your contract risks will be.
- Ensure transparency in the entire contractual process.
The lack of transparency in your contract lifecycle can lead to revenue loss, clause errors, increased costs to correct these mistakes, etc. These unwanted issues can be resolved with an automated contract lifecycle management tool.
Transparency can be improved with automation. For example, every step taken in a contract management product like Contract Hound will be documented and records can be pulled out when required. You no longer need to manually backtrack to find out who made the version edit as it will all be recorded in the system backlog.
- Consider risk sharing or transfers.
When your contract involves risks that could potentially be greater than your company’s risk appetite, you need to consider the loss and how it is insured. As such, risk transfers in these methods can be considered:
- Purchasing additional insurance coverage for your business.
- Set specific liability terms in the contract to limit the amount of liability taken on by your company.
- Negotiating certain indemnity terms in the contract such that your business will not be bound to legal consequences after providing monetary compensation to the affected parties.
- Automate your contract management processes.
The status of every stage of your contract process can be viewed within Contract Hound. Moreover, a centralized platform like this allows you to view approval workflow progress such as people involved in the contract process, recent edits to the document, etc. This can also act as a form of evidence for contract compliance and audits as every step is documented in the platform.
Automating your workflows also removes the manual labour of having to individually track each step in your contract lifecycle. Notifications and reminders can be set to avoid missing deadlines and late payments. Furthermore, being able to manage and allocate tasks and store documentation of the whole process will also improve the efficiency of your contract approval process and reduce potential risks in the long run.
- Use e-signatures.
E-signatures (such as with Docusign) are more convenient and efficient as compared to traditional signing practices. Moreover, with the E-sign act passed in 2002, electronically signed contracts are also considered legally binding.
They are also more secure as they mitigate other users from tampering with the contract and can be signed anywhere.
Mitigate Your Contract Risks By Automating Your Contract Lifecycle Management Processes With Contract Hound!
Contract risk management and adequate mitigation practices are important in ensuring business continuity for every company. Risks will be inherent in every contract agreement, but contract and risk managers can work together to mitigate these risks with the adequate tools and processes in place.
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