Risk Attitudes and the New ERM Program
There are four different Risk Attitudes that are found among business managers:
Conservators who are concerned that the environment is extremely risky and they must be very careful.
Maximizers who believe that the environment is fairly benign and that they need to take risk to be rewarded.
Managers who believe that the environment is risky but can be managed with the help of experts.
Pragmatists who do not know whether things are risky or not because they do not believe that anyone can know the future.
Now you are tasked with creating a new ERM program for your firm and how can you use knowledge of these Risk Attitudes to help you?
The first thing to do is to recognize which of those four attitudes predominates in the decision-making of your firm.
This question is a little tricky, because that is not the same thing as the Risk Attitude of the head of the firm in all cases. Good leaders may choose a path for their firm that is based upon the capacities and circumstances of the firm, even if they might prefer a different strategy if they were blessed with unlimited resources and no constraints.
But in the end, you can look at the decisions of the firm over a period of time and discern which Risk Attitude is driving firm decisions and orient the new ERM program to the predominant Risk Attitude.
If the predominant risk attitude is Conservator, then the first place to take your ERM program is to worst case losses. The risk management system can be based upon a series of stress tests, where the stresses are worst cases. The exposure to these worst cases can be added up and reported regularly. A limit system can be established based upon these worst case exposures to make sure that the exposure does not accidentally get any higher. Hedging and reinsurance programs should be considered to reduce the extent of these losses. Risk management decisions will always be made with loss potential in mind.
If the predominant risk attitude is Maximizer, then the risk management system should be focused on sales. The risk reports will be risk weighted sales reports. In addition, they should clearly show the amount of profit margin in the sales so that the risk weighted sales can easily be compared to the profit margin. Maximizers will want to make sure that the company is getting paid for the risk that it takes. Note that there are two kinds of Maximizers. Those who believe that you can lose a dollar per thousand and make it up on volume and those who believe that a sale without a profit is not a sale. Stay away from the first type. A company run by them will not last long. Risk management decisions will always be made with revenue in mind.
If the predominant risk attitude is Manager, then the risk management system will sooner or later be based upon an Economic Capital Model. As the model is built, you can start to build the systems and reports that will work off of the model for capital budgeting, product pricing, risk reward monitoring and risk adjusted incentive compensation. The Managers will very much want to form a risk tolerance for the firm and to base the risk limits off of the tolerance and to create a process for monitoring those limits. Risk adjusted return is the banner for Managers.
If the predominant risk attitude is Pragmatist, then the risk management system will need to focus first on the spread of risk. Reports will show the degree to which the firm holds very different risks. Otherwise, risk reports will need to be flexible. The Pragmatists will be irregularly be changing their minds about what they think might be most important to pay attention to about risk. And whatever is the important topic of the moment, the risk reports need to be there to probe very deeply into that topic. Pragmatists will want a deep dive on the hot risk topic of the day and will have a very hands on approach to decision making about that issue.
Sounds confusing. But get it wrong and you will find that the key decision makers will quickly lose interest. Imagine putting the information desired by the Conservators in front of a Maximizer. Or putting the details desired by a Pragmatist in front of a Manager who wants things summarized into neat packets of information. Get it wrong and you are done for.