Risk optimisation

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Risk plays an inherent role in the development of any leading business. This is particularly true in the current economic climate, where the most successful companies are often those which effectively manage risk.

As the economy becomes increasingly globalised, companies are finding themselves exposed to more risks. Tighter margins and lean, extended supply chains have further magnified the potential effects of unforeseen events and significantly impacted company risk profiles. Leading businesses have reacted to these amplified threats by carefully analysing their risk profiles and applying new quantitative approaches to examining evolving hazards.

In times of austerity it is not possible to put in place contingency plans for every potential scenario. All businesses take risks and consequently expose their investors (and other stakeholders) to potential losses.  Recent examples include suppliers providing burgers which contained horsemeat and Boeing’s Dreamliner fleet being grounded due to tech malfunctions. Best practice is to understand each individual risk and either explicitly take the risk, or devise an approach aimed at mitigating it.

Identifying Opportunities

Many businesses misclassify risks and overly focus on those which are either relatively low impact (such as employment issues), or high impact, well documented and likely to affect the entire market (e.g. the Eurozone crisis).  At 4C, we look at risk across two key dimensions:

  • Cost: calculating how much a given event could end up costing a business
  • Probability: how likely is it that the event will occur (Figure 1)

High probability/ high cost events need to be mitigated, through hedging, or building a model designed to insulate the business.  Often the more interesting opportunities are found in the areas relating to either high or low cost, low probability events.  These scenarios were referred to as “Black Swan” events, in Nassim Nicholas Taleb’s “The Black Swan: The Impact of the Highly Improbable”. In many cases the most economical way of dealing with low probability/ high cost events is to simply communicate the threat to investors and explicitly take the risk.

Different industries and companies choose to manage risk in distinct ways. Investors are often better able to absorb a particular risk than the company itself, as part of their diversification. The airline industry, for example, is made up of companies which frequently self-insure their own fleets. This means the investors shoulder the potential cost of a major incident, rather than purchasing expensive insurance that may not provide full compensation.  British Airways is one of the companies which has adopted this approach.

Businesses should think hard before investing in solutions such as the hedging of commodity costs and instead consider clearly communicating risk strategy to investors. By explicitly linking performance to commodity pricing, investors can build a clear understanding of the overall risk vs. benefit analysis (this is an approach used by some food companies).

On the other side of the spectrum, some companies are unwittingly exposing themselves to major risks. The financial crisis demonstrated the relatively small amount of structural insurance which financial institutions had in place. Many companies were effectively self-insuring but not realising what they were exposed to. The industry as whole underestimated the risks involved in their business.  For example, there was a belief that the risk of default on mortgages in the USA should be determined on a case by case basis. In reality the probability of a default on each mortgage was highly correlated to the others.

Identifying Risks

Risks can be identified, however, most companies fail to look beyond ‘standard’ risks.  Forward looking companies are able to:

  • Identify all of the potential threats which the business is vulnerable to and their consequences
  • Estimate the probability of each scenario taking place

Determining the various threats facing a business provides a platform upon which an effective risk management programme can be built. Figure 2 provides examples of some of the various types of risks that companies face. Many risks are interlinked and often one event will act as a trigger for a multitude of scenarios. A case in point is the collapse of financial services firm Lehman Brothers in 2008, which set in motion a chain of events that continues to affect companies today.

 

When looking to determine the probability of any given event taking place, we have found that a statistical approach, backed by the right data, is usually more accurate than expert predictions. Nate Silver, author of ‘The Signal and the Noise‘, accurately predicted the outcome of the 2012 USA election in all 50 states. Whilst most experts were swayed by comment and perspective on events, Silver’s statistical approach allowed him to foresee Barack Obama’s comfortable victory.

Generally speaking data relating to past events can, at the very least, provide an estimate of the probability of an event occurring.  Once the overall approach to managing and tracking risk is laid out, a monitoring process can be put in place to understand changes in the probability of particular events occurring. On the other hand, when trying to predict the likelihood of an event for which there is very little data, or, in the words of Donald Rumsfeld a “known unknown”, it is best to apply common sense coupled with statistical analysis.

Prioritising and Contingency

When deciphering potential risks, businesses must not only focus on the most likely disruptions but also those which could have the most dramatic impact. The necessity of this approach is illustrated by the 2010 Deepwater Horizon oil spill. In this case the National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling found that; “The companies involved in the Gulf of Mexico oil spill made decisions to cut costs and save time that contributed to the disaster”. Had these cost saving initiatives been successful they would have delivered only a fraction of the damage caused.

When Comet went into administration late last year, their suppliers found themselves in a weak position. Many vendors were unable to recoup what they were owed as they were low on the list of secured creditors. The probability of Comet going out of business was high, and consequently so was the possibility that suppliers would make a loss. The combination of high risk and limited potential benefits should have proved a red flag to many vendors.

Companies also make costly mistakes when over compensating for risks.  At 4C, we have seen many cases of clients over insuring. Although these situations typically receive less media attention, they can significantly inhibit company growth. Working with a client, 4C was able to ensure significant savings by using a less expensive solution to carry out the client’s deliveries.  Adopting the new approach meant relinquishing a percentage of the insurance paid out for lost deliveries. A thorough study demonstrated that the cost benefit vs. loss analysis, justified the risk of lowering the insurance percentage.

Building a Sustainable Model

Rather than purchasing insurance, adapting a business model to mitigate threats is often the most effective way of managing risks. In 2012, dry weather conditions in the UK severely affected crops, forcing Walkers to cease crisp production for a number of weeks. For a company which prides itself on using only UK potatoes, the possibility of a more severe drought in the future represents a huge risk.  Walkers responded by investing heavily in innovative solutions aimed at reducing dependence on water from traditional sources.

Projects include devising a way to harvest the water given off by potatoes during the cooking process and the iCrop, a device which monitors soil moisture and uses weather forecasting data to set the amount of water needed to irrigate fields.

These initiatives will not only make factories less dependent on volatile weather conditions, but also provide an advantage over competitors. Should another drought hit the UK, as one of the only available crisp suppliers, Walkers will be able to leverage its preparedness into increased sales.

Juggling Growth and Risk Management

Leading companies are taking a new approach to managing threats and thinking about risk as part of the budgeting process.  This best practice includes:

  • Having a process that identifies and captures all risks, including low probability but high cost scenarios
  • Thinking  about risk in a structured, probabilistic way
  • Consciously deciding which risks to take and which to mitigate, whilst communicating to investors the risks that they are exposed to

By adopting this strategy, businesses are able to leverage their risk management capabilities in order to increase efficiency and drive growth.

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