Archive for March 2018

Did the Three Pigs have different Risk Tolerances?

March 21, 2018

Or did they just have a different view of the degree of risk in their environment?

3 PigsBy Alex Proimos from Sydney, Australia – Three Little Pigs

Think about it?  Is there any evidence that the first pig, whose house was made off straw, was fine with the idea of losing his house?  Not really.  More likely, he thought that the world was totally benign.  He thought that there was no way that his straw house wouldn’t be there tomorrow and the next day.  He was not tolerant of the risk of losing his house.  He just didn’t think it would happen.  But he was wrong.  It could and did happen.

The second pig used sticks instead of straw.  Did that mean that the second pig had less tolerance for risk than the first pig?  Probably not.  The second pig probably thought that a house of sticks was sturdy enough to withstand whatever the world would send against it.  This pig thought that the world was more dangerous than the first pig.  He needed sticks, rather than straw to make the house sturdy enough to last.  He also was wrong.  Sticks were not enough either.

That third pig has a house of bricks.  That probably cost much more than sticks or straw and took longer to build as well.  The third pig thought that the world was pretty dangerous for houses.  And he was right.  Bricks were sturdy enough to survive.  At least on the day that the wolf came by.

The problem here was not risk tolerance, but inappropriate parameters for the risk models of the first two pigs.  When they parameterized their models, the first pig probably put down zero for the number of wolves in the area.  After all, the first pig had never ever seen a wolf.  The second pig, may have put down 1 wolf, but when he went to enter the parameter for how hard could the wolf blow, he put down “not very hard”.  He had not seen a wolf either.  But he had heard of wolves.  He didn’t know about the wind speed of a full on wolf huff and puff.  His model told him that sticks could withstand whatever a wolf could do to his house.  When the third pig built his risk model, he answered that there were “many” wolves around.  And when he filled in the parameter for how hard the wolf could blow, he put “very”.  When he was a wee tiny pig, he had seen a wolf blow down a house built of sticks that had a straw roof.  He was afraid of wolves for a reason.

 

 

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Too Much Logic

March 13, 2018

Someone recently told RISKVIEWS that before a company could start a project to revitalize their risk governance structures they MUST update their Risk Appetite and Tolerance.  Because everything in an ERM program flows from Risk Appetite and Tolerance.  That suggestion is likely to be too much logic to succeed.

What many organizations have found is that if they are not ready to update their Risk Appetite and Tolerance, there are two likely outcomes of an update project:

  1. The update project will never be completed.
  2. The update project will be completed but the organization will ignore the updated Risk Appetite and Tolerance.

An organization will make a change when the pain of continuing on the existing course exceeds the pain of change.  (paraphrased from Edgar Shein)

So if an organization is not yet thoroughly dissatisfied with their current Risk Appetite and Tolerance, then they are not likely to change.

So you can think of the ERM program as the combination of several subsystems:

  • Governance – the people who have ERM responsibilities and their organizational positions – all the way up to the board.
  • Measurement – the models and other methods used to measure risk
  • Selection, Mitigation and Control – the processes that make up the every day activities of ERM
  • Capital Management – the processes that control aggregate risk including the ORSA.
  • Risk Reward Management – the processes that relate risk to prices and profits

When management of an organization is dissatisfied enough with any one of these sub systems, then they should undertake to revise/replace/improve those sub systems.

These sub systems are highly interconnected, so an improvement to one sub system is likely to increase dissatisfaction with another sub system.

For example, if the Governance sub system is not working.  People are not fulfilling their ERM related responsibilities which they may not really understand.  When this subsystem is set right,  people are aware of their ERM responsibilities and then they find out that some of the other sub systems do not provide sufficient support for them.  They get dissatisfied and urge an upgrade to another sub system.  And so on.

This might well result in a very different order for updating an ERM program than the logical order.

However, if the update follows the wave of dissatisfaction, the changes are much more likely to be fully adopted into ongoing company practice and to be effective.

WaveBy Malene Thyssen – Own work, CC BY-SA 3.0,https://commons.wikimedia.org/w/index.php?curid=651071

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