Risk Management is about making prudent business decisions. When the decisions are limited to insurable hazards, there are sufficient risk management tools to make a reasonable decision. Risk maps, risk management information systems and industry benchmarks allow one to make confident recommendations between risk transfer, risk retention, risk avoidance or other solutions.
When one is faced with business risks, such as whether to build a new factory in China or to invest $100 million into research or a marketing campaign, the decisions get far more complex. As risk management evolves to play a more crucial role at the strategic-decision level, it must facilitate these types of choices.
The major challenge is that traditional tools, such as risk maps, don't necessarily support these higher-level decisions. In fact, they might cause biased outcomes.
As psychologists Daniel Kahneman and Amos Tversky aptly demonstrated in their Nobel-winning work, people have strong biases that override rationality when decisions about risk are being made. Even knowing the precise probabilities and severities will not neutralize these biases. Frameworks such as risk maps inflame these biases. By focusing on only negative outcomes, they create a strong sense of risk aversion and drive overly cautious decisions.
Risk managers must develop new models and tools that take into account the shortcomings of human rationality and biases that tend to outcomes that are overly risk averse or risk seeking. After all, we purport to be the experts on risk; if we don't understand how people react to risk when making big decisions, our credibility will surely suffer.
Fortunately, there is a ready solution that will allow us to not only correct for these biases and shortcomings, but also help establish risk management in a consultative role within the organization.
Over the past 40 years, Ronald Howard and Carl Spetzler of Stanford University, sometimes working with Kahneman and other experts, have developed a framework that produces decisions while correcting the biases that lead to bad outcomes. They have field tested their work with billion-dollar, strategic-level decisions at Fortune 500 companies.
It is not a hypothetical solution; it is ready to be applied. They call it Decision Analysis, a term that will soon be a part of every forward-thinking risk manager's lexicon.
Decision Analysis identifies the biases that impede rational decisions and employs a framework that corrects them. Anyone who has ever sat in a meeting with more than three people where a decision had to be made will recognize these biases. The most common bias, according to Spetzler, is the "comfort zone." People tend to not want to leave their zone, preferring instead to do things "the way we have always done them."
In their framework, Spetzler and his colleagues provide a systematic method of addressing and eliminating this bias on a given decision. The solution is a bit too complex to cover in this column, but overall, it is very simple and elegant. Best of all, it is readily available and implementable.
One often hears the laments of those struggling to implement Enterprise Risk Management programs or of those seeking a "seat at the table" for risk management, and anyone who has attempted to implement ERM is aware of the challenge of establishing credibility around the role of the risk manager in the decision-making process.
Application of knowledge from other disciplines such as decision analysis, however, strengthens and lends credibility to risk management.
BEAUMONT VANCE manages risk for Sun Microsystems Inc.
October 1, 2006
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