A challenge for risk management experts
The intent of this post is to present a more complex risk evaluation scenario for risk management experts to comment on. That advice should be valuable for all of us.
First, some background
In a simple situation, an event or situation may be assessed as having a defined likelihood and potential impact. People like to show this on a heat map.
But, events and situations are not always that simple. Any possible event or situation can have a range of likelihoods and impacts. Consider the potential for an earthquake to strike a town in California where your business operates. There is a range of likelihood (of an earthquake in that location) and impact (on the business):
- 1% $10 million
- 2% $5 million
- 3% $1 million
- 4% $100,000
- 4% $50,000
- 5% negligible
All told, there is a likelihood of an earthquake of 23%, but the range of impacts is wide.
For those who measure the risk based on likelihood multiplied by the potential impact, the range translates to:
- 1% $10 million $100,000
- 2% $5 million $100,000
- 3% $1 million $30,000
- 4% $100,000 $4,000
- 4% $50,000 $2,000
- 5% negligible negligible
An argument can be made that each of these is a risk situation that should be evaluated. Some would therefore focus only on the larger scenarios. I am fine with that in this case.
But what if the situation is different? Let’s say we are considering a decision on whether or not to expand into Ethiopia. There are multiple risks, extending from (for example) damage to corporate reputation if employees engage in bribery, the loss of facilities if they are damaged in periods of civil unrest, to the risk that employees will be harmed or even be killed. The aggregated range of likelihood and impact is:
- 1% $200 million
- 2% $100 million
- 3% $50 million
- 3% $10 million
- 4% $5 million
- 5% less than $1 million
Ours is a company with annual revenue of $2 billion and profits of $250 million, so these risks are significant. Why is management considering the initiative? The Marketing people estimate the potential upside (the reward or opportunity) as substantial as well:
- 10% $100 million additional profit
- 20% $80 million additional profit
- 25% $50 million additional profit
- 20% $10 million additional profit
- 5% $5 million additional profit
- 5% break even
- 5% $5 million loss
- 5% $10 million loss
- 5% $15 million loss
- How would you evaluate the situation and advise management?
- Would your evaluation change if the potential upside estimate from Marketing changed:
- If the upside increased from 10% of $100 million profit to 15%?
- If the highest possible operating loss was limited to $5 million?
Please share your approach so all of us can benefit – and discuss.