Assessing Emerging Risks: Obstacles and Opportunities
Companies often struggle to articulate the precise relevance of complex global and emerging risks for their business. Being clear from the outset about how the assessment of major uncertainties can support management decisions will help shape the analyses and gain support of senior-level decision-makers.
Weight of Inertia
To provide directional clarity, companies tend to underplay strategic uncertainty and the threats posed by shock events and alternative futures. Companies that take a limited or sluggish approach to global and emerging risks leave firms vulnerable to events that can shatter growth and reputations.
Incidents spiraling out of control might result in a credit rating downgrade or a fire sale of assets, should free cash flows fail to cover emergencies. And should the business environment fundamentally shift, the outcome might be underperforming investments, declining market share or obsolescence.
Many companies experience institutional resistance to this agenda, usually unspoken. In efforts to cope with new demands from boards and regulators, risk management has tended to toward process and efficiency over scope and analytical richness.
By focusing on the predictable and controllable, companies can be blind to risks that might individually not be unexpected, but might combine to produce highly unwelcome surprises. To properly anticipate key factors of value determination, risk management frameworks need to be more forward-thinking and ambitious.
In addition, risk analysis is often delayed in strategic and financial planning and called on simply to provide a sanity-check on decisions already made and identify solutions for manageable risks. It is striking that, according to surveys undertaken by Marsh McLennan and their research partners, risk professionals acknowledge that risk forecasting is getting harder, yet also suggest that the emerging risks agenda remains a low priority.
Against this backdrop, four hurdles need to be overcome: informational, analytical, behavioral and organizational.
Intelligence on global and emerging risks is usually imperfect and often changing. Separating noise from key drivers and triggers of change is difficult, but pursuing the mantra that you can only manage what you can (easily) measure can result in overlooking what is most important. These informational challenges, allied with high levels of uncertainty about how key risks might develop, complicate the task of combining external information with financial planning assumptions and operational realities. Extreme outcomes with low probabilities tend to get lost in simulation processes that provide an aggregate view of earnings volatility. This is one barrier to securing senior management support.
Another barrier is the tendency of individuals to downplay patterns in unfamiliar external data and risks that appear more distant. This sometimes happens because analyses threaten key interests or because the ability to control outcomes is limited.
Finally, institutional issues can cloud significance and result in inertia, for example, unclear ownership of the emerging risk agenda, weak integration with corporate processes, the habit of handing off responsibility to working groups and local offices and informational overload at senior level. Outside regulated industries, there is often reluctance to resource central functions (especially when growth is weak) and in some markets, the growing influence of activist investors in the boardroom has deprioritized long-term resilience in favor of short-term outcomes.
All these factors dilute appreciation of the threat and can restrict action to ad hoc, anecdotal reporting and the application of local fixes rather than more fully considered cross-firm solutions.
Recognition of Value
The primary reason for investing in the analysis of global and emerging risks is to strengthen strategic, financial and operational resilience. This is particularly important for large companies with complex footprints, business lines and supply chains, but also a concern for smaller companies, which increasingly face similar challenges. The effort to do so may also leave them better positioned to take advantage of sharp changes in the business environment, where there is a potential upside to be harnessed. The goal should be to achieve a generic or wide-ranging resilience, as preparing “for everything” is too costly and risks can be self-deceiving when actual events inevitably follow a course not fully anticipated.
This is not, however, to militate against the need for specific strategies to counter distinct threats, for example, imminent shocks such as a pandemic outbreak or longer-range issues such as declining water availability in certain regions.
As directors more fully embrace their risk responsibilities after the roller coaster ride of the past decade, tricky questions about inchoate threats are increasingly common at corporate board meetings, often requiring more than just fast thinking by chief risk officers and chief financial officers in response.
Questions may stem from a desire to understand the potential impact of fast-moving events on quarterly results, but they may equally derive from an interest in the generation of long-term value or a more general concern about corporate reputation and investor sentiment.
Beyond tracking and reporting on global and emerging risks to support good governance, more in-depth analyses can provide value in three distinct areas
1—Challenge the ambitions of the corporate strategy and long-term planning. Analyses can help test assumptions of the future, for example, the robustness of market demand, the reliability of supply countries and the stability of the competitive landscape. Generating plausible tail-event scenarios can help stress-test earnings and key financial ratios against the materialization of complex adverse situations. Key questions include:
- Viewed through a risk lens, are the expected objectives for long-term strategies achievable?
- What is the range of financial outcomes (positive or negative) that might result?
- Would the risk to assets and personnel be acceptable, should certain threats escalate and crystallize
2—Evaluate the likely effectiveness of risk mitigation measures. Companies need to be sure that risk response efforts are focused on the most critical risks to future expectations. Although individual emerging risks may not be listed among the top risks, they can often be the underlying drivers or amplifiers of other, more clearly scoped risks.
Anticipating how key risks might evolve is critical to ensuring that mitigation actions in whatever form—strategy adjustment, capital buffers, asset divestment, financial hedging, insurance, business controls, personnel evacuation—are sufficient to keep the company within risk tolerances and on the right footing to forestall emerging crises. Key questions include:
- Do we understand the timeframes in which events might play out and the potential impacts on different parts of our business?
- What is our view on second- and third-order effects?
- How well will our current risk response strategies and investments serve us?
3—Include in the assessment of major transactions and off-strategy ventures. The attractiveness of major acquisitions or investments may look different against a backdrop of certain emerging risks; such considerations should feed into investment committee deliberations. This allows company leaders to get a better view on the alignment between risk and reward, and turn away from ventures that have a downside potential that may not be obvious or manageable (and for which the firm would not be adequately compensated). Key questions include:
- What does the stand-alone valuation of a potential transaction look like under particular risk scenarios?
- What do these risk scenarios mean for the risk profile of the combined post-acquisition entity, especially with regard to risks that are largely outside the company’s control?
- To what extent can key concerns be affordably resolved?
This piece first appeared in The Emerging Risks Quandary from the Marsh McLennan Companies Global Risk Center.