Managing Risk for Unlikely but Catastrophic Events

June 6, 2011
Enterprise Risk Management (ERM) programs may help businesses prepare for and respond to incidents that might not have a high likelihood of occurring but are capable of yielding catastrophic results.

Stuart I. Greenbaum, Ph.D., management expert at Olin Business School, Washington University in St. Louis, pointed out that disasters such as the Fukushima Daiichi nuclear crisis in Japan are challenging to plan for financially, especially when the odds of them happening are low. Even so, these low-probability disaster scenarios too often are overlooked by businesses and deserve more attention and planning. ERM programs, he stressed, could help businesses prepare.

“ERM is a process, and effective ERM is all about process integrity,” Greenbaum said. “Thus, we can think of ERM as protection against the inclination to ignore those risks that are most menacing and inchoate. ERM elevates vigilance and thereby reduces the probability of calamitous events.”

ERM programs address more than financial or insurable hazards; they cover a range of risks, including strategy, operations, reputation, finance, compliance and information. While even the best ERM programs cannot prevent catastrophic natural disasters, such programs can serve several useful functions, such as managing the response to the incident.

“Calamities are inescapable, but their costs are not altogether foreordained,” Greenbaum explained. “ERM reduces both direct and indirect costs of untoward events. Typically, for financial institutions, calamities, especially those owing to moral hazards, are accompanied by regulatory sanctions and class-action lawsuits. The best protection against such knock-on effects is a credible ERM program. Well-documented and thoughtfully structured processes for managing existential risks will be the most disarming response to the inevitable question of what was done to protect the organization against enterprise risk.”

ERM not only is a process, Greenbaum said, but also a frame of mind. “It is a collective assertion that the organization will bring its best talents to bear upon the challenge of avoiding surprises that threaten sustainability,” he said. “It will consciously and judiciously forego current earnings in order to reduce the probability and severity of existential hazards.

“ERM can never eliminate disastrous outcomes, only those of our own making,” he added.

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