Authors note. The ideas in this article parallel the ideas presented in, “How the Boards Role in Strategy fulfills a Risk Management Responsibility,” featured in the April, 2009 edition of Director magazine, written by Hugh Goldie of the Exchange Group, Ken Smith of SECOR Consulting, and Peter Stephenson of Meridian Consulting.
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Risk is a hot topic for boards and they are being challenged to make the time to become more involved in risk management. This article illustrates how boards can make the time.
Risk is like the “elephant” in the Indian legend, The Blind Men and the Elephant. The six men experienced the elephant as something small, like a snake, a spear, or a rope. They didn’t experience the big picture; the whole elephant. They were like those in the financial services marketplace who were aware of the bubble in their own corner, but failed to see the industry-wide risk contagion.
What does the “Risk Elephant” look like?
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Risk is a hot topic for boards and they are being challenged to make the time to become more involved in risk management. This article illustrates how boards can make the time.
Risk is like the “elephant” in the Indian legend, The Blind Men and the Elephant. The six men experienced the elephant as something small, like a snake, a spear, or a rope. They didn’t experience the big picture; the whole elephant. They were like those in the financial services marketplace who were aware of the bubble in their own corner, but failed to see the industry-wide risk contagion.
What does the “Risk Elephant” look like?
It's bigger than we typically think. Frank Knight, (1) a University of Chicago Professor, identified two distinct types of risk. We are most familiar with “Measurable risk.” It’s the type we manage when we buy car insurance. Insurance companies measure past car accidents and use probability theory to create models that predict the likelihood that we, and the others in their insurance pool, will have an accident in the future.
The risk models used by the failed banks in the financial services market place, failed to manage this type of risk.
The risk models used by the failed banks in the financial services market place, failed to manage this type of risk.
Boards Work with Uncertainty
Boards tend to work with the second type of risk characterized by Knight as “uncertainty risk.” Probability theory has little relevance in managing uncertainty risk because we have nothing to measure. For example, if we decide to invest $50 Million in developing a new product we’re unlikely to have a large data bank on which to build a probability model to predict our success. We do know that events or situations will occur, created by the economy or our competitors, that could help or hinder our success. We can’t be sure of how or when they will appear. And we can’t be sure of how it will affect us. That doesn’t mean we can’t manage uncertainty risk and prepare for its possible outcomes.
Boards tend to work with the second type of risk characterized by Knight as “uncertainty risk.” Probability theory has little relevance in managing uncertainty risk because we have nothing to measure. For example, if we decide to invest $50 Million in developing a new product we’re unlikely to have a large data bank on which to build a probability model to predict our success. We do know that events or situations will occur, created by the economy or our competitors, that could help or hinder our success. We can’t be sure of how or when they will appear. And we can’t be sure of how it will affect us. That doesn’t mean we can’t manage uncertainty risk and prepare for its possible outcomes.
Lighting the Road
We manage uncertainty risk in order to light the road we follow in executing our plans. Managing uncertainty shines a spotlight on the dark corners and rough turns we may encounter so we can attempt to avoid them or minimize their affects (downside risks). It sets up beacons that can help us find the smoother stretches that could hasten and expand our our success (upside opportunities).
We manage uncertainty risk in order to light the road we follow in executing our plans. Managing uncertainty shines a spotlight on the dark corners and rough turns we may encounter so we can attempt to avoid them or minimize their affects (downside risks). It sets up beacons that can help us find the smoother stretches that could hasten and expand our our success (upside opportunities).
Brains not Computers
Managing uncertainty is a forward-looking, intuitive process done by a human brain (not a computer) on the basis of its knowledge, imagination, capacity for solving complex problems, tolerance for ambiguity, ability to see the bigger picture, and ability to learn from previous experience. Managing uncertainty risk requires us to think objectively and with an open-mind in order to see possible trends, patterns, and relationships presented by the data which may not be readily apparent in any documentation.
These are the attributes of skilled directors. They are the reason why a skilled, experienced, and balanced, board is so important. They are the reason why, for boards, risk management is a legitimate task.
The Challenge.
Managing uncertainty is a forward-looking, intuitive process done by a human brain (not a computer) on the basis of its knowledge, imagination, capacity for solving complex problems, tolerance for ambiguity, ability to see the bigger picture, and ability to learn from previous experience. Managing uncertainty risk requires us to think objectively and with an open-mind in order to see possible trends, patterns, and relationships presented by the data which may not be readily apparent in any documentation.
These are the attributes of skilled directors. They are the reason why a skilled, experienced, and balanced, board is so important. They are the reason why, for boards, risk management is a legitimate task.
The Challenge.
Skill is only one factor in the governance equation. Time is another. Ten years ago time was not an issue for directors. With today’s increasing demands from shareholders, regulators, and their own workplaces, directors are hesitant to add to their workload.
The Question.
The Question.
How can your board make better use of director time to engage in managing uncertainty risk?
The Answer.
The Answer.
Make management of uncertainty risk the explicit method for executing your board’s responsibilities. Doing so will formalize an approach which many boards are already using by default. Channel your board’s agenda, the mindset of directors, and the understanding of the CEO, into a formal approach for managing uncertainty risk. You will build on existing director skills, clarify the relationship between the Board and CEO, and create better governance as a result.
Three steps are required.
1. Build uncertainty risk management into existing board activities and processes.
2. Better use available director time by adding additional resources to gather data, and to analyse and prepare risk assessments.
3. Ensure directors have the skills and experience required to work in this new reality of managing uncertainty risk.
Build Uncertainty Risk Management into Existing Board Activities.
Three steps are required.
1. Build uncertainty risk management into existing board activities and processes.
2. Better use available director time by adding additional resources to gather data, and to analyse and prepare risk assessments.
3. Ensure directors have the skills and experience required to work in this new reality of managing uncertainty risk.
Build Uncertainty Risk Management into Existing Board Activities.
Your board likely uses some or all of the processes necessary to manage uncertainty risk. They are strategic planning, CEO oversight, management succession, board development, and the audit of management’s regulatory submissions.
1. Create a formal map for each process including expected outcomes. (You likely have the map for audit review and use it every year)
2. Define each process step in terms of the calendar timing, expected outcomes, and task responsibilities for both the board and the management team.
3. Create a “process introduction” for use just prior to the start of activities for the year. This will put both the board and management on the same page as the process begins.
Identify the Data Required and the Means for Analysis.
1. Create a formal map for each process including expected outcomes. (You likely have the map for audit review and use it every year)
2. Define each process step in terms of the calendar timing, expected outcomes, and task responsibilities for both the board and the management team.
3. Create a “process introduction” for use just prior to the start of activities for the year. This will put both the board and management on the same page as the process begins.
Identify the Data Required and the Means for Analysis.
Most boards rely on data provided by the CEO. They are reluctant to bypass the CEO or to incur the additional cost to engage outside sources. Effective management of uncertainty requires access to a broader understanding of the issues; including industry issues, and a need for independent perspectives beyond those of the CEO and management. Boards need assistance in gathering and assessing this broader spectrum of data.
1. Define the data required in each process for the boards understanding of the issues, the source(s) of the data, and resources required for analysis prior to use by the board. Sources could include the CEO, the Internal Auditor and external experts.
2. Establish the time and means for presenting data to the board for its understanding and assessment. This includes the typical board package and presentations by the CEO, but may also include outsider presentations or individual interviews with directors outside of board meetings. The usual board meeting routine may change.
3. Establish the criteria and means by which the board will accomplish its evaluation of each issue.
Acquire Directors Whose Skills and Experience Reflect the New Reality
The Institute of Corporate Directors (Canada), the National Association of Corporate Directors, (USA), the Institute of Directors, (Britain) the Institute Company Directors, (Australia) and the Institute of Directors in New Zealand Inc. have adopted “Director Competencies.” This document specifies sixteen desired competencies and the board tasks to which they relate. They match the needs for risk management. We recommend Director Competencies as a guide for director recruitment.
Risk is a hot topic for boards.
Increased board involvement in managing uncertainty risk is a legitimate challenge for boards. Your board can respond positively by adopting uncertainty risk management as the explicit means by which it executes its responsibilities. Better governance will result.
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Hugh Goldie is a Director, and Past Chair of the Manitoba Chapter of the Institute of Corporate Directors. His recent book is titled, Confidence at the Board Table; How Directors Manage Risk and Deliver Superior Governance. Hugh is an Associate of the Exchange Group and can be reached at hugh.goldie@exg.ca.
(1)Frank H. Knight. (1885 -1972) Professor of Economics, University of Chicago. First book published in 1921, Risk, uncertainty and profit. He was responsible for injecting reality into risk management.
1. Define the data required in each process for the boards understanding of the issues, the source(s) of the data, and resources required for analysis prior to use by the board. Sources could include the CEO, the Internal Auditor and external experts.
2. Establish the time and means for presenting data to the board for its understanding and assessment. This includes the typical board package and presentations by the CEO, but may also include outsider presentations or individual interviews with directors outside of board meetings. The usual board meeting routine may change.
3. Establish the criteria and means by which the board will accomplish its evaluation of each issue.
Acquire Directors Whose Skills and Experience Reflect the New Reality
The Institute of Corporate Directors (Canada), the National Association of Corporate Directors, (USA), the Institute of Directors, (Britain) the Institute Company Directors, (Australia) and the Institute of Directors in New Zealand Inc. have adopted “Director Competencies.” This document specifies sixteen desired competencies and the board tasks to which they relate. They match the needs for risk management. We recommend Director Competencies as a guide for director recruitment.
Risk is a hot topic for boards.
Increased board involvement in managing uncertainty risk is a legitimate challenge for boards. Your board can respond positively by adopting uncertainty risk management as the explicit means by which it executes its responsibilities. Better governance will result.
________________________________________
Hugh Goldie is a Director, and Past Chair of the Manitoba Chapter of the Institute of Corporate Directors. His recent book is titled, Confidence at the Board Table; How Directors Manage Risk and Deliver Superior Governance. Hugh is an Associate of the Exchange Group and can be reached at hugh.goldie@exg.ca.
(1)Frank H. Knight. (1885 -1972) Professor of Economics, University of Chicago. First book published in 1921, Risk, uncertainty and profit. He was responsible for injecting reality into risk management.
