Integrating Risk with Strategy-Setting – Analyzing Strategic Risks

by Jim DeLoach

corporatecomplianceinsights

Strategic risks arise when (a) the business model is not effectively aligned with the strategy or (b) one or more strategic assumptions lag behind industry realities and the strategy does not reflect the new conditions. Arising from internal process issues and/or disruptive change in the external business environment, these risks can be lethal if not known to management and the board. Because they are not susceptible to precise measurement like operational risks, often they require a qualitative analytical framework to analyze them.

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Strategic risks are often “compensated” risks as the potential for upside is sufficient to warrant accepting the downside exposure. For example, the risks associated with initiating operations in new markets, introducing new products, or undertaking large research and development projects are “compensated” risks because the act of taking them is inseparable from executing the enterprise’s strategy.

By contrast, “uncompensated” risks are one-sided because they offer the potential for downside with little or no upside potential. Our experience is that many managers often bring a “controls mindset” to assessing risk because they think of risk as uncompensated. This mindset does not work when assessing strategic risks, because those risks are more about what we don’t know.

Strategic risk analysis assists senior management with understanding the critical assumptions underlying the strategy and uses contrarian analysis to challenge those assumptions. It works as follows.

Begin by defining your strategic assumptions. These assumptions are management’s “view of the world” during the strategic planning horizon, e.g., the enterprise’s capabilities, competitor capabilities, customer preferences, technological trends, capital availability and economic trends, among other things.

In summary:

(1)    Define the assumptions that are implicit in the strategy.

(2)     Select the most critical assumptions for further review.

Develop contrarian statements for the most critical assumptions. These statements negate the strategic assumptions by specifying what might happen to invalidate the assumptions and how much it would hurt.

For example, the Japanese utility operating the Fukushima nuclear plant assumed a worst-case scenario of an earthquake causing a tsunami of more than 20 feet as extremely low risk. A contrarian statement might have asserted a 40+ foot tsunami hits the plant, which was a plausible 1,000-year event based on recent geological studies. This flaw in the model ensured that no subsequent dialogue would occur regarding the threat of the more extreme scenario to the plant, the company or even the entire industry.

Once contrarian statements are defined, management should select the ones with the greatest impact on the company if they were to transpire, i.e., the statements management needs to examine more closely because they cause the most damage.

In summary:

(3)    For the selected assumptions, develop a corresponding contrarian statement.

(4)     Select the highest-impact contrarian statements for further review.

Analyze the plausible and not-so-plausible scenarios that could make the highest-impact contrarian statements happen. The contrarian statements with the highest impact reflect situations that would likely arise from events about which the organization currently lacks sufficient information and that management would likely rationalize after-the-fact: “Why didn’t we see it coming?”

In instances requiring additional analysis, management should identify scenarios involving an improbable event or combination of events that could occur in the future and make the contrarian statement a reality. The final list of scenarios, which should be a workable number, should be evaluated using such attributes as impact, persistence and velocity.

In summary:

(5)       For the highest-impact contrarian statements, brainstorm relevant scenarios.

(6)       Consider relationships and similarities among scenarios to narrow down the list to a manageable level.

(7)       Rate the list of selected scenarios for impact, persistence and velocity.

(8)       For the scenarios with the greatest effect, identify drivers evidencing that the scenarios are developing or have occurred.

Articulate the implications of high-impact contrarian statements. Implication statements address two questions: “What do we do if the critical assumption underlying our strategy is no longer valid?” and “How would we know if our assumption is no longer valid?”

Management decides on (a) the appropriate key risk indicators, trending metrics and other information to be incorporated into the scope of the competitive intelligence function with the intent of creating an early warning system, and (b) the appropriate response plans needed to increase the company’s response readiness for scenarios with a high velocity.

In summary:

(9)    Identify key risk indicators, trending metrics and other relevant information, monitoring processes and techniques, and response readiness plans.

(10)  Define response plans for scenarios with a high velocity.

While we can never say with certainty that we know what we actually don’t know, we can apply techniques that force knowledgeable managers to think strategically and challenge strategic assumptions constructively in a safe environment without fear of reprisals. The contrarian analysis process develops new ideas that can help make the strategy more robust. This process integrates risk assessment into strategy-setting.

This article was written by Jim DeLoach  and originally published on corporatecomplianceinsights

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