When approaching risk financing decisions, the first step is to establish your foundation for risk appetite before taking a deep, analytical dive into a key risk or risks to investigate. (See part one of this series in the January issue and part two last month.)
Finally, by using the “as-is” and unmitigated modeling results, it is possible to arrive at an alternative strategy.
When digesting the results from the graph below, an organization considers three data points that are consistent with the risk management objectives listed earlier, says Keith DeCoster, managing director of Aon Risk Services.
“The first data point is the average total cost of risk, which is the average value of all of the outcomes generated by the model,” says DeCoster. “The second is the risk tolerance breach point, the point at which each of the curves crosses the risk tolerance line (blue line). Finally is tail exposure, which is the average value of the risk beyond a certain confidence level.”
Smart Business spoke with DeCoster about how to use data points to help analyze your company’s strategy.
How can the data points help you analyze your strategy?
When considering these three pieces of information, you can see that the average (or expected value) total cost of an unmitigated strategy is slightly better than the ‘as-is,’ or current, strategy. However, the current strategy breaches risk tolerance levels less often and provides measurable protection against tail exposure.
From these observations, we can conclude that the current strategy does provide value. But why stop here? With the quantitative framework in place, we can now ask whether there is a better risk response strategy that we should consider
In the figure below, the organization considers additional mitigation, which has a cost, to evaluate the potential benefit. The new strategy (gold line) has a lower average total cost of risk, breaches the risk tolerance level less often and provides better protection against tail exposures than the current strategy.
Therefore, we would recommend using capital to implement the new strategy, as the tradeoff is worth it along all three evaluation streams.