How can an organization better understand risk-reward tradeoffs?
An element of probability needs to be introduced. Otherwise, there is no basis for evaluation. For risk appetite, this should include the critical volatility drivers for the organization. In theory, every driver could be considered; however, this is not practical. Therefore, a proxy for reality should be created. Drivers can be revenue- or expense-driven, the economic conditions that impact retail sales or a catalyst used in a manufacturing process.
Once critical drivers have been captured, a portfolio driver model can be created to build the proxy performance model, which establishes a measurement of the probability of breaching critical performance measures. For example, if an organization identifies hazard risk, interest rates, investment returns, commodity process, health benefits and human capital as the key organization performance drivers and risks, a model can be constructed for each. For each iteration, both the raw (no mitigation) and net (post-mitigation) impacts are calculated, leading to an outcome for each driver and an overall portfolio impact to the organization. Models of various types can be used for the drivers, including historically based frequency and severity. Running thousands of iterations of the portfolio model will generate a distribution of potential outcomes resulting in a true picture of volatility.
Finally, incorporate management parameters. If there is a deviation from forecast that management will react. If an organization is not going to hit a quarterly target, management may determine that some spending can be pulled back to help meet the objective. If these nuances are not captured, the model will not emulate management behavior and will produce results that imply that it is more likely that a performance threshold is breached.
What is the next step after establishing a risk appetite analysis?
The risk appetite analysis is now a foundation to determine if a new risk management strategy is a good use of capital and provides an acceptable risk-reward tradeoff. Once the foundation for risk appetite is established, a deep, analytical dive into a key risk or risks can be taken to investigate if alternative mitigation strategies prove to be a better management strategy.
Next month: Part two looks at measuring risk impact and quantifying risk.
Keith DeCoster is managing director of Aon Risk Services. Reach him at (317) 237-2400 or [email protected]. Also contributing to this article were Jay Gotelaere, managing director and actuary, and Mike Giacobbe, managing director, Americas business development leader. Reach Gotelaere at (312) 381.2772 or [email protected]. Reach Giacobbe at (312) 381-4185 or [email protected].