How to Assess Risk in Your Contracts
By David Parks
Recently, I wrote an article on how to identify risk in your contracts. It looked at four key steps you can take to figuring out where risk exists in your legal agreements and how contract management software can help you in the process. This article is a follow-up to that blog and addresses the next risk management step which is how to assess risk in your contracts.
Risk Probability and Consequence
Once you’ve identified a risk, you need to assess what that risk means to your organization and assign a score based on the level of risk identified for each contract. The more comprehensive and complete the assessment, the more accurate your results.
When it comes to assessing risk, there are two main factors to consider — the risk probability and the risk consequence. In other words, what is the likelihood of the risk occurring and what would be the impact if it does occur. There’s also a third dimension to assessing the risk, which is the time factor. How does the risk probability and consequence of a contract change over time?
For example, the consequence could be high early in the agreement and then become low over time. The probability, however, could be moderate in the beginning but increase over time. Let’s say you have a contract with a financial term that isn’t very favorable in the beginning stages of the agreement. As time passes and milestones are met, the consequences of not meeting the financial term diminish.
Once you assess your risk consequence and probability you can then apply scores to them. You can do this by correlating different numeric values to each level of probability and consequence in order to generate a risk scoring methodology. A very high probability may be a 10 whereas a very low probability may be a 1. You can then do the same for the risk consequence.
Risk Thresholds
Once your contract risks are scored, another key factor in assessing them is to establish risk thresholds for your organization. Realizing that risk is inherent in just about every legally binding agreement, it’s important to determine how much risk you are willing to accept. This will allow you to recognize contracts that are within and beyond your risk threshold.
For example, perhaps you identify that any delays in approval associated with Master Services Agreements with healthcare contracts result in lost business 40% of the time. Depending on the value of those deals, you can determine if those delays are an acceptable risk or not. By scoring contract risks and defining your organization’s tolerance levels, you can decide if you are willing to accept the risks associated with certain contracts.
How Contract Management Software Helps
When using contract management software, all your contracts are centralized and searchable in a contract repository. The key, however, is leveraging that centralization to provide valuable and actionable business insights to assess risk in your contracts.
The average centralized contract repository contains a great deal of data such as dates, names, types of clauses, financial terms, dollar values, and other data points. It’s important your contract management software allows you to harness and structure your contract data in way that it can be easily searched for, and rolled up into, useful reports and dashboards that provide the visibility you need to assess contract risk levels and create risk scores.
By capturing all the different data points using a complete and structured approach to contract data management, you can calculate risk scores based on variables and thresholds that you establish in the system. You can look at risk factors such as a contract over a certain dollar value that is not using a specific Limitation of Liability clause, or a contract renewing in a certain month of the following year, or maybe you want to factor in when an outdated version of a California Governing Law clause was used.
Regardless, the ability to quickly capture this information and apply a risk score to each contract that’s specific to your thresholds and policies makes reporting one of the most critical benefits to your risk management process. And dashboards take that valuable report data and present it in a graphical, user-friendly format that you can use to assess the risk profile of your contracts.
Takeaway
Learning how to assess risk in your contracts is an important step in your risk management strategy. After you’ve identified risk, you need to understand the probability and consequence of it occurring, apply scores to weight it, and then determine your acceptable risk thresholds. Contract management software can play a significant role in helping you throughout your risk management process. In my next blog on this topic, I’ll examine the next risk management step which how to mitigate risk in your contracts.
