Rational Adaptability

In any given risk environment, companies holding a risk perspective and following an ERM program aligned with external circumstances will fare best.

In order to thrive under all future risk regimes, a firm ideally would follow a strategy of Rational Adaptability. This involves three key steps: 1. Discernment of changes in risk regime, 2. Willingness to shift risk perspective, and 3. Ability to modify ERM program. The difference between Rational Adaptability and the process of “natural selection” where firm go through a “natural” process of change of risk attitude and risk strategy is conscious recognition of the validity of differing risk perspectives and proactive implementation of changes in strategy. Individuals often find it difficult to change their risk perspective. Therefore, a company that wishes to adopt Rational Adaptability must ensure that its key decision-makers represent a diversity of risk perspectives.

Furthermore, the corporate culture and the managers themselves must value each of the risk perspectives for its contributions to the firm’s continued success. An insurance company is best served by drawing on the respective expertise of underwriters, actuaries, accountants, contract attorneys and claims experts—and members of one discipline should not feel slighted when the expertise of another discipline is called upon. Similarly, any firm that wishes to optimize its success under each of the various risk regimes should have Maximizers, Conservators, Managers and Pragmatists among its senior management; and those who hold any one of these risk perspectives should acknowledge that there are times when another perspective should take the lead. The CEO must exercise judgment and restraint, shifting among strategies as needed and shifting responsibilities among the management team as required.

Rational Adaptability recognizes that during Boom Times, risk really does present significant opportunities—and it is appropriate to empower the Profit Maximizers, focusing ERM efforts on Risk Trading to ensure that risks are correctly priced using a consistent firm-wide metric. When the environment is Moderate, the firm employing Rational Adaptability will give additional authority to its Risk Reward Managers, examining the results of their modeling and using these to reevaluate long-term strategies. And in times of Recession, a firm following Rational Adaptability shifts its focus to Conservation: tightening underwriting standards and placing special emphasis on firm-wide risk identification and risk control. Resisting the pull of his or her own personal risk perspective, the CEO must be willing to listen—and act—when others in the firm warn that the company’s risk management strategy is getting a little too concentrated on one and possibly not the optimal risk attitude and risk strategy.

Yet in each risk regime, there are companies following strategies that are not well aligned with the environment. Some of these firms muddle along with indifferent results and survive until their preferred environment comes back. Others sustain enough damage that they do not survive; some change their risk perspective and ERM program to take advantage of the new environment. Meanwhile, new firms enter the market with risk perspectives and ERM programs that are aligned with the current environment. Since many of the poorly aligned firms shrink, die out or change perspective— and since new firms tend to be well-aligned with the current risk regime—the market as a whole adjusts to greater alignment with the risk environment via a process of “natural selection.”

This an excerpt from the article “The Full Spectrum of RIsk Management”  co-authored by Alice Underwood.

This post is a part of the Plural Rationalities and ERM project.

 

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Tags: Enterprise Risk Management

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