Home > Risk > Scenario Analysis is a Great Tool in Risk Management

Scenario Analysis is a Great Tool in Risk Management

September 13, 2021 Leave a comment Go to comments

I have been a fan of scenario analysis for a very long time. Not only is it a great way to understand the current situation, whether it is a problem, which options are available, and what actions to take, but it is far more effective than making decisions based on a list of risks.

Scenario analysis helps everybody view risks and opportunities together and in context.

I highly recommend a 2019 article How to Use Scenario Analysis to Manage in Uncertain Times.

Here are some high points:

  • Every single decision in an organization is made under a certain degree of uncertainty.
  • Often, leaders make these decisions based on anticipated events, along with corresponding best-case and worst-case predictions about what might happen. Whether or not these predictions will actually come to pass is unknown at the time the decision is made.
  • Scenario analysis is a method for creating responses to various future events with the aim of reducing uncertainty and maximizing the chances of achieving a desired outcome. This process requires investments of people, time, and money. Imagination also comes into play as managers use scenario analysis to determine or invent possible courses of action to take so the organization can reduce its overall risk and maximize its value.
  • Historically, scenario analysis arose out of military planning during World War II. During the war, it was a means to offer specific descriptions of different futures; summarize and synthesize variables into a coherent picture for each possible future; suggest multiple and distinct choices that each future would entail; and increase the likelihood of achieving desired outcomes by exploring a range of responses or solutions.
  • Economic historians say that scenarios were first used in the post-war business world by the Shell Oil Company to evaluate oil price variability and consumption patterns, so that capital investments would be shifted into areas offering the best-predicted financial return. The practice quickly spread, and scenario analysis is now used by companies in most industries.
  • In conducting a scenario analysis, specific future uncertainties and corresponding realities are evaluated by exploring different possible ways to arrive at a desired outcome. This requires assessing internal capabilities, such as the strengths and weaknesses of the operation, and external factors, such as the existing and future opportunities and threats in the business environment.
  • Four features make scenarios analyses a particularly powerful tool for understanding uncertainty and making business decisions.

First, these thought experiments expand thinking by developing a range of possible outcomes, each backed by a sequence of events that could lead to the desired outcome. According to psychologists, this is particularly valuable because it helps counteract the common biases of expecting the future to resemble the past and expecting that change will occur only gradually. By demonstrating how and why things could quite quickly become much better or worse in new and unexpected ways, scenarios improve readiness for the range of possibilities the future may hold.

Second, these analyses help protect against groupthink, which can inhibit the free flow of ideas. In business meetings, people often agree with whatever the highest-ranking person in the room says. This is especially true in hierarchical companies, where employees will wait for the most senior executive to state an opinion before venturing their own, which often magically reflects that of the executive. Scenarios allow companies to break out of this trap by providing several established options, which can serve as a “political safe haven” for contrarian thinking.

Third, in large corporations there is typically a strong status quo bias. Scenarios can help challenge conventional wisdom when status quo-based assumptions may no longer hold true. Having alternatives built into the process provides a less threatening way to deviate from the status quo.

Fourth, scenarios are particularly useful in navigating the kinds of extreme events recently seen in the world economy, such as natural disasters, pandemics, terrorism, active shooters, or ransomware. Scenario analyses enable management to steer a course between the false certainty of a single forecast and the confused paralysis that often strikes in chaotic times. When well executed, they allow strategy to be based on a sophisticated understanding of probabilities that maximize the chances of a desired outcome.

Risk officers can lead scenario analysis discussions as a facilitator, but they can also help management understand the several ranges of potential effects and their likelihoods (both benefits and harms) under each scenario.

My internal audit team has also facilitated such discussions.

What do you think?

  1. John J Brown
    September 13, 2021 at 7:55 AM

    Totally agree Norman! Scenario analyses, coupled with strategic foresight, is powerful. Here are a few snippets from a recent presentation (note that these statements are paraphrasing experts in this area):

    Strategic foresight is a recent discipline, originating in the 1960s, that allows us to create functional views of alternative futures and possibilities. Rather than predicting or forecasting the future, foresight allows us to examine the external environment for trends and leverage those insights to create images of the emerging landscape.

    Bill Barton, former center head for American Express’ Consumer Lending Operations, contrasted vision with strategic foresight: “It was vision that inspired the invention of the automobile. It was foresight that anticipated traffic jams, accidents and pollution.“

    Foresight acknowledges that the future is ambiguous and aims to prepare decision-makers for how the future may change. Scenarios are parallel stories about how the future may unfold. Together these tools (strategic foresight and scenario analyses) better prepare organizations for whatever future arrives.

  2. September 13, 2021 at 8:30 AM

    Norman, I can’t express my support enough on this topic. In my former role, the chief economist along with the CAO and risk management group developed 10 scenarios once the business plan was developed. We then applied these scenarios where management had to investigate and calculate the potential impact on the business plan. Management developed “risk indicators” to tell us if the scenario outcomes were beginning to occur, and developed risk mitigation plans for each scenario just in case they were to occur. Looking back a year later, we found 7 out of 10 scenarios did indeed occur either partially or in whole. Because executives were accountable for plan development and execution, we were able to still meet the business plan despite these occurrences. So … this is a very useful tool.

  3. John Fraser
    September 13, 2021 at 10:57 AM

    Scenario Analysis is definitely an essential part of ERM. Chapter 15 of our 2021 book “Enterprise Risk Management: Today’s Leading Research and Best Practices for Tomorrow’s Executive” – Second Edition is an excellent chapter on “Scenario Planning as an Enrichment of Enterprise Risk Management” by Henk Krijnen, formerly of Shell’s corporate strategy department he played a pivotal role in establishing new approaches for risk and scenario analysis. Just for readers’ information.

  4. September 14, 2021 at 2:44 AM

    The results of scenario planning should be an essential part of any board paper seeking to justify major expenditure or significant changes in policy. IA should ensure this is happening. Probably one of the shortest but most important checks that IA can do. Now that’s agile auditing!

  5. Roxana Brown
    September 14, 2021 at 3:44 AM

    I have been a risk professional pretty much all my life (various areas of consumer financial lending). Scenario analysis is like water around me, fish, so I use it in my personal life also for important decisions without even realizing I am doing it.
    It came as a total surprise to me when I figured it out this way of thinking doesn’t come natural to most people.

  1. September 13, 2021 at 8:05 AM
  2. September 15, 2021 at 9:42 PM

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