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The long view: Getting new perspective on strategic risk

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The long view: Getting new perspective on strategic risk is an Economist Intelligence Unit report that explores how companies manage long-term strategic risks in their business. The report is sponsored by ACCA and Willis.

The Economist Intelligence Unit bears sole responsibility for the content of this report. Our editorial team executed the online survey, conducted the interviews and wrote the report. The findings and views expressed in this report do not necessarily reflect the views of the sponsors.

Our research for this report drew on two main initiatives:

We conducted an online survey of almost 500 executives from around the world in October 2011. The survey included companies from a wide range of different sectors. All respondents have direct responsibility for, or influence over, their firm's risk management, either as CEO or board-level executive (42%), as chief risk officer or other dedicated risk executive (39%), or as a non-executive director (19%).
To supplement the survey results, the Economist Intelligence Unit conducted a programme of qualitative research that included a series of in-depth interviews with industry experts.

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The long view: Getting new perspective on strategic risk

  1. 1. The long viewGetting new perspective on strategic riskA report from the Economist Intelligence Unit Sponsored by
  2. 2. The long view Getting new perspective on strategic risk Contents About this research 2 Interviewees 3 Executive summary 4 Chapter 1: Bringing the future into focus 6 Chapter 2: A seat for risk at the top table 11 Chapter 3: Roles and responsibilities for risk 16 Conclusion 23 Appendix: Survey results 25 © The Economist Intelligence Unit Limited 2011
  3. 3. The long view Getting new perspective on strategic risk About this research T he long view: Getting new perspective on strategic risk is an Economist Intelligence Unit report that explores how companies manage long-term strategic risks in their business. The report is sponsored by ACCA and Willis. The Economist Intelligence Unit bears sole responsibility for the content of this report. Our editorial team executed the online survey, conducted the interviews and wrote the report. The findings and views expressed in this report do not necessarily reflect the views of the sponsor. Our research for this report drew on two main initiatives: l We conducted an online survey of almost 500 executives from around the world in October 2011. The survey included companies from a wide range of different sectors. All respondents have direct responsibility for, or influence over, their firm’s risk management, either as CEO or board-level executive (42%), as chief risk officer or other dedicated risk executive (39%), or as a non-executive director (19%). l To supplement the survey results, the Economist Intelligence Unit conducted a programme of qualitative research that included a series of in-depth interviews with industry experts. The author was Rob Mitchell and the editor was Iain Scott. We would like to thank all those who were involved in this research. © The Economist Intelligence Unit Limited 2011
  4. 4. The long view Getting new perspective on strategic risk Interviewees l Andrew Blau, president of Global Business Network l Dr Hugh G Courtney, professor of the practice of strategy at the University of Maryland l Michael Denison, research director at Control Risks Group l Steve Fowler, chief executive at the Institute of Risk Management l Javier Gimeno, professor of strategy and Aon Dirk Verbeek chaired professor in international risk and strategic management at INSEAD l Peter Johnson, vice-president of strategic planning at Eli Lilly Co l Andrew Kakabadse, professor of international management development at Cranfield University l Anne Nobles, chief ethics and compliance officer and senior vice-president of enterprise risk management at Eli Lilly Co l Richard Pascale, an associate fellow at University of Oxford’s Saïd Business School l Michael Raynor, director at Deloitte Consulting LLP l Roland Rechtsteiner, managing partner of the global risk and trading practice at Oliver Wyman l Martin Reeves, senior partner and managing director at Boston Consulting Group l Harri Spolander, chief risk officer at Fortum l Tiger Tyagarajan, chief executive at Genpact l Freek Vermeulen, associate professor of strategy at London Business School l Chris Worley, senior research scientist at the Center for Effective Organisations at the University of Southern California © The Economist Intelligence Unit Limited 2011
  5. 5. The long view Getting new perspective on strategic risk Executive summary D uring times of uncertainty and change, current challenges will often take priority over long-term plans. With the euro zone crisis still in full swing and with developed markets facing the prospect of a double-dip recession, many business leaders will naturally focus their attention on the immediate future. They will seek assurances that their short-term financing needs will be met and will pay careful attention to the quarterly results to detect signs of market deterioration. This short-term focus is ingrained in institutional structures and thinking. Most chief executives will enjoy an average tenure of around six years, which means there are few incentives to bring long-term problems to the top of the agenda. A relentless focus on shareholder value creation has encouraged business leaders to prioritise short-term profits and share price moves over long-term performance. Incentive structures have often reinforced this focus by rewarding managers for meeting short-term targets. Short-term metrics will always be important indicators of performance, and companies will always need the ability to take decisions quickly and adapt to immediate opportunities and threats. But a retreat into the present will reduce a company’s chances of long-term, sustainable success. Business leaders must therefore combine their skills of adaptability and addressing immediate challenges with a focus on longer-term risks and opportunities. At a time when the world is changing so rapidly, it may seem as though any attempt to think about the future will be doomed to failure. In one respect, this is true. No one can predict the future and the current pace of change means that it is more difficult than ever to attempt it. But by considering how different futures might evolve, and ensuring that their organisation is equipped to deal with a range of outcomes, business leaders will not only be better prepared for the future but will also be more knowledgeable about their current situation. This report explores current approaches to long-term strategic planning and risk management. Based on a global survey of senior executives with responsibility or influence over their company’s risk management, and a programme of interviews with industry experts and commentators, the report looks at how companies link risk management with strategic planning. Key findings from this research include: © The Economist Intelligence Unit Limited 2011
  6. 6. The long view Getting new perspective on strategic risk Long-term risk management is rising on the agenda for many business leaders. Over the past year, almost one-half of companies say that they have made their risk management more forward- looking. At the most senior level of the organisation, discussions about long-term prospects and risks are becoming more frequent. Just over one-third of respondents say that their board and senior management has increased the time that they allocate to long-term risk analysis. Links between risk management and strategy are strengthening in many organisations. More than one-half of respondents say that their risk function plays a formal role in strategy-setting and in evaluating new market investments. A similar proportion of respondents believe their organisation is effective at linking risk management with strategy. It is an encouraging sign that companies are adopting a more rigorous approach to considering the risks associated with their strategy, and that risk functions are gaining a more influential position within organisations. Many companies are using scenario planning, but few embed it into the overall strategy process. A large majority of companies are already using scenario planning and other tools to identify and assess long-term risks. But few companies are embedding these techniques into their overall strategic decision-making. Only 20% of respondents say that scenario planning plays a vital role in helping their company to formulate and adapt strategy in uncertain times. Companies also admit that they may need to allocate more time to a longer-term view. More than one-half of respondents agree that they should spend more time thinking about the risks they will face ten years from now. The time horizons for strategy and risk are often misaligned. Some companies are making long- term strategic plans without a proper consideration of the associated risks. Asked about the maximum period over which they consider strategic objectives, 58% say that their timeframe is greater than three years. But asked about the maximum period over which they consider risks, the proportion with the same time horizon is much smaller, at 44%. In other words, strategy discussions are less likely to incorporate an assessment of risk as the time horizon increases. A short-term focus among business leaders can prevent a more thorough assessment of long-term risks. Asked about the barriers that can prevent their company from taking a longer-term view of its risk exposure, respondents point to an executive management that is more focused on immediate risks as the chief culprit. At a time of considerable uncertainty in the external environment, this short-term focus is understandable. But boards and senior management must move beyond this myopia and ensure that immediate priorities do not crowd out longer-term strategic planning and risk management. Risk functions need to do more to challenge entrenched views of the future. Despite progress towards a more widespread long-term assessment of business risks, there is a danger of complacency. Business leaders can often have deeply embedded mental maps of how the future might evolve. It is notable, for example, that almost one-half of respondents agree that looking into the future merely tends to confirm what they already know rather than providing them with new information. This highlights the importance of a risk function with the stature to question strategic assumptions. Two- thirds of respondents agree that the risk function needs to do more to challenge management’s view about how the future might unfold. © The Economist Intelligence Unit Limited 2011
  7. 7. The long view Getting new perspective on strategic risk Key points n Long-term thinking may be important, but most companies admit that they are not good at it n Many organisations regard long-term risk analysis as a thought exercise rather than as a key input to strategy n Changing business culture and using better tools may help to alter this mindset Chapter 1: Bringing the future into focus “I t is tough to make predictions, especially about the future.” This famous quote, attributed to the Danish physicist Niels Bohr, neatly summarises the challenge facing companies when they try to set long-term plans. Despite their best efforts, and despite a plethora of consultants, tools and methodologies that try to convince them otherwise, the future is inherently unknowable. So-called “black swan” events, such as the global financial crisis, can quickly unravel even the best-laid plans. And in an environment of extreme volatility and uncertainty, many executives will no doubt wonder why they make bets on the future at all. Prediction may be impossible but this does not mean that thinking about the future is pointless. Indeed, in sectors with long-term investment horizons, such as energy or pharmaceuticals, it is absolutely critical to explore a range of potential future scenarios. This vision of the future may not always be right, but it will at least provide some guidance on the range of potential outcomes for a particular investment. “If you take your long-term opportunities seriously, then you’d better take the long-term risks seriously as well,” says Michael Raynor, director at Deloitte Consulting. Even in sectors with much shorter product life-cycles, such as fast-moving consumer goods, a long- term focus is important. Demographic or generational changes can create new dynamics for business, which can have a dramatic impact on long-term prospects. Major new threats, such as climate change, pose considerable long-term uncertainty that will ultimately require a response from every business. And macroeconomic prospects in emerging markets will have a significant bearing on the success of new market-based investments. “If you’re wondering which emerging markets to bet on, you’ve not only got to think about ten- year population trends, but you’ve got to think about ten-year wealth distribution changes too, and if you don’t, you may end up investing in the wrong market,” says Martin Reeves, senior partner and managing director at Boston Consulting Group. Javier Gimeno, a professor in international risk and strategic management at INSEAD, the business school, argues that long-term risk management can be fundamental to corporate survival. “If you look at why companies fail, it’s usually because of a failure to identify and mitigate long-term risks,” he says. “They might miss a change in the market, or a change in technology. It takes so long to react to these risks that you need to be able to position yourself well in advance. That can only be achieved by © The Economist Intelligence Unit Limited 2011
  8. 8. The long view Getting new perspective on strategic risk Chart 1: How effective are your company’s risk functions at helping to manage the following? Rate on a scale of 1 to 5, where 1=Very effective and 5=Not at all effective. (% respondents) 1 Very effective 2 3 4 5 Not at all effective The pace of external change 8 37 34 16 5 The emergence of new and unexpected threats 10 35 36 15 4 Continuing economic volatility 6 37 40 13 4 Increasing business complexity 9 34 41 13 4 Unpredictable market demand 6 30 42 17 5 Spotting emerging opportunities 9 30 42 14 5 Dealing with long-term challenges such as climate change 6 18 35 23 17 long-term risk management.” Long-term thinking may be important, but most companies admit that they are not good at it. Less than one-half of the respondents to our survey think that their risk function is effective at managing the pace of external change or the emergence of new and unpredictable threats. Only one-quarter say they are good at dealing with long-term challenges, such as climate change (see chart 1). “Long-term risks are the most important ones of all but they are also the ones for which the available tools and solutions are not necessarily optimal,” says Professor Gimeno. Andrew Blau, president of Global Business Network, a consultancy, believes that one of the reasons companies struggle with long-term challenges is that they limit their discussions about risk to factors that are unique to their organisation. While this helps them to deal with operational risks, it is completely useless at dealing with a major external event, such as the Arab Spring. “When regimes started to fall in the Middle East and Africa, there were various multinationals with business in the region who really hadn’t factored this kind of geopolitical risk into their thinking,” he says. “They assumed that political structures were stable and that the recent past would be a good guide to the future. It’s important to take a broader view of risk, which is informed by perspectives from outside the company, and think through different scenarios about how external risks could interact with internal vulnerabilities in surprising ways.” The key, then, is not to predict the future or become wedded to a particular vision of what it might hold, but to consider a range of different possible outcomes and assess how they might affect the business. “It’s important to keep your options open and ensure that you have the flexibility to respond to different scenarios because you cannot guarantee any particular outcome in the world,” says Harri Spolander, chief risk officer at energy company Fortum. Many companies recognise that they ought to do more to think about the future. Just over one-half of the survey respondents agree that their company does not spend enough time thinking about the risks it might face ten years from now (see chart 2). But although companies recognise the importance of long-term risk analysis, it remains a minority pursuit. Among the companies surveyed for this report, only around one-quarter say that analysis of risks that may occur more than a decade into the future is a vital part of their strategy process. A further 44% conduct this kind of analysis, but mainly as a thought exercise rather than as a key input to strategy (see chart 3). © The Economist Intelligence Unit Limited 2011
  9. 9. The long view Getting new perspective on strategic risk Chart 2: Please indicate whether you agree with the following statements. (% respondents) Strongly agree Slightly agree Neither agree nor disagree Slightly disagree Strongly disagree Agility and flexibility are more important than the ability to plan for the long term 34 39 15 9 2 Our company does not spend enough time thinking about the risks it might face ten years from now 21 32 24 14 9 The relatively short average tenures of most C-level executives mean that there is little incentive for companies to look at risks more than five years into the future 22 34 21 14 9 Looking far into the future tends merely to confirm what we already believe rather than giving us any new information 11 35 25 20 9 Investors are not particularly interested in knowing what risks the company will face ten years into the future 17 29 21 22 11 It is better to bring third-party consultants in to help us think about the long-term future because they introduce fresh perspectives 12 32 27 19 10 The risk function in our business needs to do more to challenge management’s view about how the future might unfold 22 44 24 8 2 Chart 3: What do you see as the value of risk analysis that considers events more than one decade into the future? (% respondents) It is a vital part of the strategy process in our business. 24 We do this, but more as a thought exercise than as part of the strategy process—it is difficult to incorporate it into our strategic planning. 44 We do not do it because we do not believe it has value. 32 Pressure to think short-term Long-term risk management is inherently challenging. As they look further out to the future, companies will be dealing with uncertainty, rather than risk. In his 1921 treatise, Risk, Uncertainty and Profit, the economist Frank Knight defined risk as randomness with knowable probabilities, and uncertainty as randomness where the probabilities are unknown. “Long-term strategy over periods of more than ten years is much more about uncertainty than risk,” says Freek Vermeulen, associate professor of strategy at London Business School. “You really have no clue what the world is going to look like ten years from now so it can be somewhat dangerous to start measuring the probabilities of a future that may well never materialise.” By extending their risk models further into the future, companies must be aware that the data being used to populate them are increasingly unreliable. As financial institutions learned during the recent crisis, an over-reliance on models can be dangerous. “You’ve got to be careful not to make model- based decisions without reflecting on the quality of the input and output to that model,” says Roland Rechtsteiner, managing partner of the global risk and trading practice at Oliver Wyman. Besides the inherent challenges of long-term risk management, there are good reasons that executives may be reluctant to focus too much energy on the distant future. Over the past three years, volatility in financial markets and a highly unpredictable economic environment have made it difficult to anticipate what will happen from week to week, let alone ten years into the future. © The Economist Intelligence Unit Limited 2011
  10. 10. The long view Getting new perspective on strategic risk Chart 4: What, if any, do you consider to be the main barriers that prevent your company from taking a longer-term view of its risk exposure? Select up to three. (% respondents) Executive management is more focused on immediate risks 41 Pace of business is too fast to make long-term risks worth considering 36 Doubts about its risk value 33 Lack of expertise in long-term risk analysis 31 Investor focus on short-term performance means that management does not spend much time on longer-term issues 20 Lack of available tools 18 Lack of time and resources 17 Incentive structures are geared toward shorter-term issues 16 Relatively short tenure of most senior executives 7 Other, please specify 3 We do take a longer-term view of our risk exposure 8 At a time when many companies have been more worried about survival than how they will be positioned a decade from now, it is perhaps inevitable that long-term thinking slips down the priority list. Asked about the barriers that prevent their company from taking a longer-term view of its risk exposure, respondents point to a focus on more immediate risks among executive management as the key factor (see chart 4). When companies are confronted by short-term challenges, there is a temptation to turn inwards and fix the problem by increasing efficiency or eliminating redundancy. But as Mr Reeves points out, this can blind companies to the real issues. “The human reaction when faced with falling returns or volatility is to shorten the time horizon and seek out short-term tactical gains through increased efficiency,” he says. “At the very moment when companies need to look ahead, they do exactly the opposite.” Almost three-quarters of respondents agree that agility and flexibility are more important than the ability to plan for the long term (see chart 2). But while quick wits are important, these capabilities alone are not sufficient to ensure long-term success. “Agility starts with a longer view because if I haven’t thought about the future, then I won’t have a range of ideas on which to draw when the unexpected happens,” says Chris Worley, senior research scientist at the Center for Effective Organisations at the University of Southern California. “Instead, I have to make them up in the moment, which means that my decisions will tend to be focused on a very narrow range of options.” More long-standing, institutional barriers can also prevent a longer-term focus. Pressure from investors and analysts can encourage companies to focus on quarterly results at the expense of longer- term performance. “The fact that a long-term perspective is beneficial to the company is easy to grasp but it’s challenging to implement,” says Dr Hugh G Courtney, professor of the practice of strategy at the University of Maryland. “There are lots of day-to-day pressures from the financial markets that make it difficult to stand strong and have the courage to prioritise a longer-term perspective over the short-term issues.” © The Economist Intelligence Unit Limited 2011
  11. 11. The long view Getting new perspective on strategic risk Management incentive structures can reinforce this focus on short-term performance. Rewards are often geared towards short-term performance and there is only limited allocation towards longer-term ones. There is an assumption that CEOs will only last a few years in a role, and this is often reflected in their pay structures. More than one-half of respondents agree that this relatively short tenure means there is little incentive for companies to consider long-term risks (see chart 2). But despite these challenges—which are both intellectual and structural—the ability to take a longer-term focus is becoming a vital capability for survival and success in an uncertain environment. The goal is not to predict the future but to prepare for it by building up the capability to respond to unexpected events. “The strategy that you come up with may well need to change, but at least you’ve gone through the process of thinking through various scenarios,” says Professor Vermeulen. “This makes you better equipped to put together an appropriate response when something unexpected happens.” Genpact: Staying one step ahead of change time thinking about potential risks and how they could affect its business. “We run ‘what if’ scenarios in different business lines and In a young, fast-changing industry, the ability to respond quickly consolidate these across the company,” explains Mr Tyagarajan. to evolving customer needs is vital. But by identifying the early “We discuss, for example, the implications of an increase in global indicators of change, companies in highly dynamic sectors can gain protectionism and then try to think about how that might affect our a longer-term perspective that gives them an advantage over their business.” competitors. Where possible, Genpact frames these scenarios as opportunities Genpact is a business process management consultancy that as well as risks. “We look at changes in our market and think about began its life as a division within GE. It operates in a fast-growing how we might be able to capitalise on them,” says Mr Tyagarajan. sector that is barely more than a decade old. In such a dynamic “If we can identify change and then position ourselves to drive the environment, the ability to spot change early can increase the time evolution of a new market, then that is much better than simply available to formulate a response. mitigating a risk.” Tiger Tyagarajan, Genpact’s chief executive, emphasises the Although Mr Tyagarajan believes that Genpact has embedded importance of a balance between agility and foresight. “You have risk thinking at the heart of its business, he feels that the company to have your antennae out and be able pick up signals of upcoming needs to do more to think about long-term risks. “We are a very change faster than competitors,” says Mr Tyagarajan. “Our aim is young company in a young industry,” he says. “More importantly, to take advantage of the distributed intelligence throughout the the pace of change is so fast that it can drown out efforts to think organisation and identify signals of possible change. To do this, we about the very long term. But we are continuing to push our need to be close to our clients and the market.” horizons outwards. We are on a journey but we still have some way Despite the pace of change in its sector, Genpact spends a lot of to go.”10 © The Economist Intelligence Unit Limited 2011
  12. 12. The long view Getting new perspective on strategic risk Key points n Risk functions continue to take on bigger roles in their companies’ strategy development n However, risk management is still primarily viewed as an operational, rather than strategic, function n Some companies are trying a discovery-based approach, discussing risks and opportunities side by side and making decisions based on rigorous argument Chapter 2: A seat for risk at the top table S trategy development and risk management should go hand in hand. As companies make long-term plans and decide on major new investment initiatives, a rigorous and formal understanding of the risks that could derail that strategy is essential. Among the companies surveyed for this report, it is encouraging to note the substantial role played by the risk function in key strategic activities. Almost six in every ten respondents say that their risk function plays a formal role in setting overall corporate strategy, and more than one-half say that risk managers play a formal role in evaluating new market investments (see chart 5). Respondents generally think that the links between risk and strategy are strong, with more than six out of ten rating the alignment between the two as effective. This is a different picture from one year ago, when we asked the same question in a previous report in this series. Then, the proportion of respondents who said that they were involved in these activities was considerably smaller. The overall message seems to be that risk functions are taking on an increasingly significant role in strategy development. But despite this progress, other findings suggest that there is still a gulf between risk management and strategy. Asked about the maximum period over which they consider strategic objectives, 58% say Chart 5: In which of the following activities does your organisations risk function play a role formally? Please select all that apply. (% respondents) Setting overall corporate strategy 58 Providing analysis to support corporate strategy 57 Evaluating new market investments 53 Evaluating MA opportunities 43 Evaluating new geographical investments 41 Business restructuring 41 Capital raising 37 Performance management 34 Recruitment of senior executives 1811 © The Economist Intelligence Unit Limited 2011
  13. 13. The long view Getting new perspective on strategic risk Chart 6: When formulating long-term plans for your business, what is the maximum time horizon over which you consider strategic objectives or risks? (% respondents) Strategic objectives Risks One year 8 20 Up to three years 33 36 Up to five years 37 25 Up to ten years 14 11 Up to 20 years 4 3 More than 20 years 3 4 that their timeframe is greater than three years. But asked about the period over which they consider risks, the proportion with the same time horizon is much smaller, at 44% (see chart 6). In other words, a sizeable proportion of companies are considering long-term strategic plans beyond a certain timeframe without a proper consideration of the associated risks. What is causing this gap between strategy and risk? A common problem is that risk and strategy are not always well-aligned. Although they say they are involved in strategy, risk officers are often brought into the process at a late stage. By this time, senior executives are looking for information that endorses, rather than challenges, their strategy. “Chief executives don’t want to hear the risk arguments because they feel that it undermines the strategic position that is driving the company,” says Andrew Kakabadse, professor of international management development at Cranfield University. “Even in organisations where there is a high awareness of risk, it does not form part of the strategic debate and difficult issues are prevented from coming to the surface.” This problem often stems from a view that risk management is an operational, rather than strategic, function. In recent years, many companies have become much more effective at supply chain risk management, business continuity planning, financial risk and a whole host of activities that help the organisation to become more resilient. But these are tactical risks, and companies’ strategic risk capabilities are often less well-developed. “When it comes to fundamental strategic decision-making, uncertainty and risk are not analysed nearly as rigorously or systematically as the day-to-day aspects of risk management,” says Mr Courtney. “That’s surprising, because the strategic risks are often the biggest bets that a company will make.” Other findings from our survey also point to a gap in capabilities. When asked what they thought were the most important objectives of the risk function, respondents point to the identification of new and emerging risks (see chart 7). But when asked how they rate the effectiveness of their organisation at various activities, anticipating and measuring emerging risks is seen as the biggest weakness (see chart 8). The problem, it seems, is that, despite recognising the importance of a long-term, strategic approach to risk management, companies find this extremely difficult to put into practice.12 © The Economist Intelligence Unit Limited 2011
  14. 14. The long view Getting new perspective on strategic risk Chart 7: What, in your opinion, are the most important objectives of the risk management function? Please select no more than three objectives. (% respondents) Identifying new and emerging risks 59 Ensuring corporate survival 38 Enabling managers to make better business decisions 31 Minimising losses 29 Communicating key risks to stakeholders 25 Measuring and monitoring risk 25 Ensuring regulatory compliance 22 Enabling more efficient resource allocation 17 Instilling risk culture in the organisation 16 Setting and monitoring the organisation’s risk tolerance 13 Other, please specify 1 Chart 8: How would you rate the effectiveness of your organisation at the following activities? Rate on a scale of 1 to 5, where 1=Highly effective and 5=Not at all effective. (% respondents) 1 Highly effective 2 3 4 5 Not at all effective Linking risk management with corporate strategy 16 40 32 10 2 Ensuring that risk information is timely and up-to-date 10 39 34 15 2 Ensuring quality and availability of data 8 36 40 14 2 Instilling awareness of risk throughout the organisation 11 32 37 17 3 Communicating risk information to investors 12 31 35 16 6 Managing regulatory compliance 19 40 29 9 2 Anticipating and measuring emerging risks 7 35 41 15 1 Recruiting and retaining appropriate risk expertise 5 24 37 25 8 Ensuring board level awareness of key risk issues 15 42 29 11 2 Many companies understand these shortcomings and are working hard to resolve this problem. Almost one-half of all respondents say that, in the past year, they have increased the extent to which risk management is forward-looking. Just over one-third have increased the time that the board and senior management allocates to long-term risks (see chart 9). “What is starting to appear on the horizon is a greater integration between risk and strategy, and a more holistic approach that looks across the various silos that have been used to organise thinking about risk in the past,” says Mr Blau. A more strategic approach to risk requires companies to integrate it with the strategy process, ensuring that any major investments or plans are tested and challenged across all the key risk categories. “Rather than deciding on a strategy then testing it for risks and uncertainties afterwards, companies should approach their strategic discussions in a more exploratory way where they are13 © The Economist Intelligence Unit Limited 2011
  15. 15. The long view Getting new perspective on strategic risk Chart 9: Over the past year, what changes have you made to the following aspects of your risk management practices? (% respondents) Increase No change Decrease Extent to which risk management is forward-looking 49 50 1 Time horizon over which we consider risks 27 67 6 Resources allocated to risk analytics 29 67 4 Resources allocated to risk modelling 22 73 5 Board and senior management time allocated to long-term risk analysis 37 59 4 Investment in scenario planning and other long-term risk management tools 29 67 4 Formal links between risk management functions and overall corporate strategy 33 64 3 not just testing a chosen option but working with senior management throughout the process,” says Mr Courtney. This more strategic assessment of risk requires a systematic approach to thinking through the implications of a particular decision. “Companies need to accept that, with every type of strategic initiative, they are actually making a risk/return decision,” says Mr Rechsteiner. “Once you accept that every strategic move has a different risk/return implication, then you can have the whole discussion around what level of risk you are willing to take, the long-term outlook for investments and how a particular strategic initiative fits in with your overall portfolio.” In addition to taking this more structured approach to considering risks, leadership teams may also need to change the cultural framework by which they make decisions. Mr Courtney points out that many organisations use an advocacy-based, rather than a discovery-based, method to reaching strategic decisions. According to the former approach, members of the executive or non-executive team make their pitch, and those with the strongest influence or argument win. But in a discovery- based approach, the idea is to decide on the best outcome through a process of dialogue, where the risks and opportunities are discussed side by side and decisions are made on the basis of rigorous argument. “The tools that are available to manage risk and uncertainty are getting better all the time,” says Mr Courtney. “Ultimately, what needs to change are the culture and mindset issues that will enable a more rigorous assessment of risk as part of the strategy process.”14 © The Economist Intelligence Unit Limited 2011
  16. 16. The long view Getting new perspective on strategic risk Challenging beliefs at Eli Lilly to change the way we do business.” Taking a longer-term perspective on risks helps to challenge assumptions about what the future may bring. Mr Johnson believes In many companies, risk management remains a tactical activity that this is important, because our beliefs about the future are rarely that focuses on identifying and mitigating operational threats. Even explicit. “These implicit beliefs can create a lot of dissonance when in companies that have put in place enterprise risk management you’re making strategic decisions,” he says. “The very process of programmes, the focus tends to be on internal issues, rather than a talking about the future will help a management team to understand broader strategic discussion of risks and opportunities. that their current strategy is dependent on a set of beliefs about the Eli Lilly Co, the US-based pharmaceuticals company, is one way the world is going to work.” of the few companies to have embarked on the next stage of Lilly’s approach to dealing with strategic risk has become the journey—to connect and integrate risk management with more qualitative over time. The aim is to understand the four the company’s long-term strategic decision-making. Given the or five “seminal beliefs” that are the lynchpin of the company’s long-term nature of the pharmaceutical industry, with its multi- strategic choices. “By identifying these beliefs, we can think decade drug development timetables, it is unsurprising that Lilly about what would happen if they were different or wrong,” says Mr recognises the importance of a long-term perspective. “Looking at Johnson. “Even if you don’t make any explicit changes, you start to risks more than a decade into the future is an inherent part of our understand the choices you’ve made in a deeper way.” business,” says Peter Johnson, the company’s vice-president of While Lilly’s strategy team is centralised, the risk function strategic planning. “We have to make choices today about the kinds operates as a virtual team. Anne Nobles, the company’s chief ethics of diseases that we want to focus on and the value that we think and compliance officer and senior vice-president of enterprise we could get from developing a product that would be launched 12 risk management, stresses that it is important to get input years from now.” from different parts of the organisation rather than rely on an The company encourages managers to think not just about overly centralised risk function. “Our approach is to pull people the downsides of risk, but the opportunities that may be inherent together from across the business who have a range of expertise in those risks as well. “It’s a hard concept for people to grasp and knowledge,” she explains. “This enables us to draw on the initially,” says Mr Johnson. “But when they think about it, they can backgrounds of a diverse team who understand the business understand that we are trying to imagine a changing situation that dynamics but from slightly different perspectives. This is a vital tool may look like it’s a downside, but in fact represents an opportunity for helping us to think strategically about the long term.”15 © The Economist Intelligence Unit Limited 2011
  17. 17. The long view Getting new perspective on strategic risk Key points n Senior managers can become over-confident in their abilities to ascertain future risks n Boards and risk managers need to be willing to challenge management and ensure that there has been a proper discussion of risk as part of the strategy-setting process n Scenario planning can be a useful tool—but it can be dangerous if it is not done properly Chapter 3: Roles and responsibilities for risk I n the 1950s, the Canadian-born psychologist Elliott Jaques developed a theory called the Requisite Organisation. One of its arguments was that time horizons should increase in line with seniority in a company. A low-level sales executive might worry about reaching his targets for the week, while a marketing director might be focused on plans for the next year. With each layer of hierarchy in the organisation, time horizons should get longer. Those at the top of the company, the executive and non-executive management, should have the longest time horizons of all. Our survey suggests that this is broadly the case. The chief executive is the individual who is most likely to be responsible for exploring the potential impact of long-term risks, followed by the executive board. Very few companies delegate responsibility for long-term thinking to strategy departments or heads of business units (see chart 10). Chart 10: Who in your company is responsible for exploring the potential impact of long-term risks on corporate strategy? Please select one only. (% respondents) Chief executive officer 30 Executive board 19 Chief risk officer 9 Board-level risk committee 8 Chief financial officer 8 Strategy department 6 Heads of business units 5 Cross-functional committee below board level 4 No one has overall responsibility 4 Non-executive board 2 We do not conduct long-term risk management 3 Don’t know 116 © The Economist Intelligence Unit Limited 2011
  18. 18. The long view Getting new perspective on strategic risk But despite the prevailing view that the executive management and board are ultimately responsible for strategic risk management, there are barriers that can prevent them from fulfilling this role effectively. For one thing, the pace of change and complexity of the business environment means that it can be difficult to know where to start. “The challenge for people at the top is how you ration the bandwidth that you’ve got to pick those few themes that you think could be really consequential,” says Richard Pascale, an associate fellow of Saïd Business School. “The danger is that certain risks simply fall off their radar and become a tick-box exercise rather than something of substance.” Michael Denison, research director at Control Risks Group, highlights the importance of ensuring that long-term strategic discussions take place within a defined framework. “There’s no point just shoving people into a room and asking them to talk about what’s going to happen in 20 years,” he says. “There has to be some structure and organisation to the kind of things you are thinking about. It’s within that structure that you allow people to explore the types of issues that might occur.” Chief executives and other members of the leadership team need the strength of character to support a long-term focus among their team and reports. Asked to name the steps that are needed to ensure a better alignment between risk management and strategy, respondents point to a stronger risk culture and awareness among business units (see chart 11). This has to come from the top. “There are a lot of CEOs who will acknowledge the issue but unless they are willing to pull the team aside and tell them stop worrying so much about short-term issues, then it will be very tough to get longer-term thinking on the agenda,” says Mr Worley. In many companies, the management team is far removed from the coalface of the business, and this means that information about risks can be filtered out before it reaches them. It is notable that more than four out of ten C-level respondents agree that looking into the future merely tends to confirm what they already know rather than providing them with new information. In other words, they have deeply embedded mental maps about how the future will unfold. “People are systematically over-confident in many aspects of life, but particularly in their ability to predict the future,” says Mr Courtney. “We rarely see change until after the facts and we become anchored on the status quo, which Chart 11: What steps does your organisation need to take to ensure better alignment between risk management and strategy? Select all that apply. (% respondents) Stronger risk culture and awareness among business units 50 Greater risk management expertise at executive board level 45 Stronger commitment to enterprise risk management 44 Risk management needs to be more forward-looking in its approach 34 Risk managers need to present themselves more effectively as business enablers 33 Greater risk management expertise at non-executive board level 32 Perception of risk management as a “support function” needs to be eroded 29 Better knowledge of the business among risk professionals 27 Other, please specify 217 © The Economist Intelligence Unit Limited 2011
  19. 19. The long view Getting new perspective on strategic risk frames how we view signals from the market and from competitors.” Business leaders who are unwilling to hear dissenting opinions and who surround themselves with teams who share their viewpoint are particularly unlikely to miss the early indicators of new risks and opportunities. “You might find that one manager perceives something as a risk but another will not,” says Professor Gimeno. “The danger, then, is that something that is an early warning tends to be suppressed because nobody wants to recognise those voices that are dissenting from the majority of opinion.” The non-executive board also has an important role to play in ensuring that a focus on the longer term is maintained. “With the responsibility for the long-term health of the organisation sitting squarely in their lap, the board needs to push management to think beyond the next quarter or fiscal year,” says Mr Worley. “The more they can get involved in encouraging management to think longer term, the better they will be fulfilling their own responsibilities.” Rather than be compliant and simply sign on the dotted line, boards need to be willing to challenge management and ensure that there has been a proper discussion of risk as part of the strategy-setting process. “You want people on the board who are willing to play devil’s advocate,” says Professor Gimeno. “It’s important to have dissenting opinions about what the future will look like, but all too often what you get is support for strategy rather than challenge.” Although board members may not be experts in risk management, having at least one member who can take responsibility for long-term risks helps to ensure an independent perspective and a challenge for management. Survey respondents see board-level risk expertise as one of the key requirements for ensuring a better alignment between risk and strategy (see chart 11). “There should be board members or executives whose responsibility is to assess risk who report to the chairman,” says Professor Kakabadse. “This ensures that their views cannot be blocked by executive management.” The role of the risk function Chief risk officers and risk functions continue to grow in influence and stature within many organisations. More than one-half of respondents say that risk management will play a bigger role in helping the company to meet its organisational priorities compared with a year ago. Among financial services companies, this proportion rises to 63% (see chart 12). Chart 12: How would you describe the contribution of risk management to meeting your organisational priorities in the coming year, versus the past year? (% respondents) Risk management will play a bigger role than a year ago 55 Risk management will play a smaller role than a year ago 5 Risk management will play the same role as a year ago 38 Don’t know 218 © The Economist Intelligence Unit Limited 2011
  20. 20. The long view Getting new perspective on strategic risk Chart 13: How would you rate the quality of managerial engagement between the risk function and the following individuals or groups when considering long-term risk issues? Rate on a scale of 1 to 5, where 1=Very high and 5=Very low. (% respondents) 1 Very high 2 3 4 5 Very low Not applicable Chief executive officer 44 30 18 4 2 0 Chief financial officer 31 36 19 71 6 Other executive board members 12 33 31 12 3 9 Non-executive board 5 25 29 20 6 15 Head of business units 10 30 31 15 5 8 Other business managers 3 18 32 22 122 13 Chart 14: How frequently does your risk function report in writing to the board? (% respondents) Every quarter 34 Monthly 22 Every six months 13 Annually 10 Weekly or more often 6 Less than annually 5 Never 10 Risk functions are also forging strong relationships with the most senior levels of the organisation. More than three-quarters of respondents say that the quality of managerial engagement between the risk function and the chief executive is high, and just over two-thirds offer a similar assessment for the relationship with the chief financial officer (see chart 13). The frequency of engagement also seems to be fairly high. Just over six out of ten respondents say that their risk function reports to the board in writing either quarterly or more frequently (see chart 14). But despite this progress, there can still be a perception that risk functions play a supporting role in business, rather than a strategic one. “There continues to be a frustration among risk managers that they are seen as a necessary part of the business rather than as an integral one,” says Mr Denison. Two-thirds of respondents agree that risk functions need to do more to challenge management’s view of what the future might hold. It takes huge strength of character for CROs to break free from traditional perceptions of the risk function and play this role. But having stronger representation of risk at a senior level could be hugely valuable. “A really effective CRO needs to be someone who has the stature to take on the mindset and cultural issues in the C-suite,” says Mr Courtney. “If they can influence decisions at that level, or even change the way the board makes those decisions, then they will have made a significant contribution.” So how should risk mangers ensure that they play a role in key strategic decisions? Steve Fowler,19 © The Economist Intelligence Unit Limited 2011
  21. 21. The long view Getting new perspective on strategic risk chief executive of the Institute of Risk Management, argues that risk officers need to put themselves forward and take a proactive approach rather than waiting to be asked for input. “The most successful risk managers will deliberately find out what the chief executive’s pet project is and will then review the risks and responses to ensure the project succeeds, rather than fails,” he explains. It is also important for them to speak the language of business, rather than hide behind complexity and obfuscation. “Risk managers do themselves a great disservice if they start talking in technical jargon,” says Mr Fowler. “Chief risk officers need to speak the language of the business they are in, which means understanding finance, understanding the financial impact of risks, both upside and downside, and making sure that they communicate with the key decision-makers in the firm on the same level.” A broader discussion Better alignment between senior management and the risk function is important, but this nexus should not be the only source of information about long-term risks and opportunities. “Most of the risks that can really cause companies to come unstuck are integral to the business, so although it makes sense to have an independent risk function to ensure that checks and balances are in place, it doesn’t always makes sense in a context of where the knowledge to act on those risks actually lies,” says Mr Reeves. By instilling a broader culture of risk across the organisation and ensuring an awareness of risk concepts across the broader business, companies will have a better chance of spotting new threats and responding appropriately. At the same time, the discussion of risk moves from one that primarily concerns downside threats to one that accompanies upside opportunities as well. “In the future, identifying and assessing risk should be a strategic conversation among multiple parts of the organisation” says Mr Blau. “This enables the company to develop a holistic view of risk that spots potential threats as well as opportunities for new growth and advantage.” In this way, risk is no longer compartmentalised in the risk function, but becomes the responsibility of everyone across the business. While the technical aspects of risk will remain the responsibility of risk managers, the identification of risk, and the conversations about its implications, can take place anywhere in the company. “Large organisations have tremendous numbers of eyes and ears on the ground in places around the world, and finding ways to tap that distributed perspective on the challenges that their business is facing is extremely valuable and important,” adds Mr Blau.20 © The Economist Intelligence Unit Limited 2011
  22. 22. The long view Getting new perspective on strategic risk Scenario planning takes centre stage Nearly 40 years after Royal Dutch Shell first them to formulate and adapt their strategy in commercialised its use to enable a better uncertain times, a larger proportion—46%—see it understanding of its business at the time of major merely as a useful input, rather than an integral part oil price shocks, scenario planning has become an of the process. A further 18% see it as an interesting integral part of the risk management toolkit in many thought exercise but not something that has a major companies. Among our respondents, 72% say that they bearing on their strategy (see chart 16). currently use scenario planning, while a further 19% This assessment may suggest that companies say that they plan to do so in future (see chart 15). are not making best use of their scenario planning “Scenario planning helps companies to develop a exercises, but Mr Courtney argues that companies do more complete map of possibilities so that they are not need to align their scenarios with every decision. able to pick up weak signals on the periphery,” says “Scenario plans don’t necessarily need to inform the Mr Pascale. “It’s a very helpful exercise to stretch big strategic decisions on the day, but they do begin executives beyond the dimensions that they normally to frame the longer-term opportunities and threats focus on and to push them to become more nimble in that companies might face,” he explains. “They start their response to weak signals as they start to move to lay the groundwork for the investment paths that to the centre.” companies might need to explore.” But despite its widespread adoption, companies While undoubtedly a useful input to the strategy take different approaches to aligning scenario process, scenario planning also carries its own planning with their overall strategy. While 20% of risks. If executives see it as a way of predicting the respondents say that it plays a vital role in helping future, or to validate particular strategies, then it Chart 15: Which of the following tools does your company use or intend to use to identify and assess long-term risks? Please select one for each row. (% respondents) Currently use Intend to use Do not intend to use Scenario planning 72 19 10 Third-party forecasts 60 19 22 Risk mapping 51 31 18 Horizon scanning 43 29 29 Other, please specify 22 14 63 Chart 16: Which of the following statements best describes your company’s approach to using scenario planning? (% respondents) It is a useful input to helping us formulate and adapt our strategy in uncertain times 46 It plays a vital role in helping us formulate and adapt our strategy in uncertain times 20 It is an interesting thought exercise but does not have a major bearing on our strategy process 18 It helps us to assess the robustness of our business model and strategy over the longer term 7 It helps us better anticipate the unexpected 5 We do not think that scenario planning has any real relevance to our business 421 © The Economist Intelligence Unit Limited 2011
  23. 23. The long view Getting new perspective on strategic risk can lead companies down the wrong course. “If you scenario planning should be considered as a way to approach scenario planning as a means to select the equip the company for multiple possible outcomes. most optimal strategy based on the probabilities “Even though you may not be describing an event you ascribe to different scenarios, then it’s useless which is going to happen, you are actually thinking at best and probably very dangerous because you about the processes of contingency planning,” are almost certain to be wrong,” says Professor says Mr Denison. “So the content may not be quite Vermeulen. “You’re better off not doing scenario right but you’re instilling a mindset which means planning at all than doing it dogmatically.” that something is not going to take you completely Rather than be seen as a way to predict the future, by surprise.”22 © The Economist Intelligence Unit Limited 2011
  24. 24. The long view Getting new perspective on strategic risk Conclusion E fforts to build stronger links between risk management and strategy are at a relatively early stage. But there are encouraging signs of change. Risk management is outgrowing its origins as a tactical, operational discipline and becoming more tightly embedded with the strategy-setting process. Business leaders are opening the doors of the boardroom and becoming more willing to be challenged by the chief risk officer. Governance changes that enshrine the independence of the risk function are making this process even easier. Based on our research into long-term risk, we have identified ten capabilities that companies should develop to ensure that they have a closer alignment between their strategic decisions and risk management: Prediction is impossible, but thinking about the future is still important. Companies that set their strategy based on a deterministic view of the future are doomed to fail. Instead, the goal of risk management should be to explore multiple potential scenarios and test strategic options against them. Business leaders must be willing to challenge their own assumptions about the future. Deeply held mental models and a tendency towards groupthink mean that leadership teams will often share assumptions about how the future will unfold. As part of the strategy process, business leaders should be willing to have these assumptions challenged. Companies must accept that strategies are hypotheses. The management writer Henry Mintzberg said that strategies are to companies what blinkers are to horses. In an uncertain world, companies must accept that strategies are hypotheses, and test them regularly using robust risk management techniques and dialogue. Risk should be fully integrated with the strategy process. If risk officers are only brought into the strategy process once the key decisions have been made, it makes it very difficult for them to challenge executive management. Instead, risk should be integrated with strategy and be able to provide independent challenge to management assumptions throughout the process. Adopt a discovery-based model for strategy development. In many companies, strategy is determined on the basis of influence and power. Rather than adopt this advocacy-based model,23 © The Economist Intelligence Unit Limited 2011
  25. 25. The long view Getting new perspective on strategic risk companies should shift to a discovery-based one, in which a process of dialogue and discussion is used to arrive at optimal strategy. Discussions about the future need structure. Informal discussions about the long-term future will have limited value. Instead, companies need to adopt a structured approach, using techniques such as scenario planning and horizon scanning, to explore potential outcomes. Risk should be the responsibility of everyone across the business. Companies should work hard to overturn perceptions that risk is the responsibility of risk functions. By building a broader culture of risk and distributing awareness across the entire organisation, companies stand a much better chance of identifying new and emerging threats at the periphery. Boards need to steer senior management towards a longer-term focus. As the stewards of the company’s long-term prosperity, non-executive directors should play an active role in preventing executive management from becoming too bogged down in immediate priorities. Risk management needs independence to give it stature. Chief risk officers should play a vital role in challenging management and applying a risk filter to strategic decisions. But if they report to executive management, it is difficult for them to do this. Companies should therefore ensure that risk officers report directly to the board. This will give them the stature and independence they need to challenge executive management. Discussions about risk can uncover opportunities as well as threats. Risk and opportunity are two sides of the same coin. By integrating risk with strategic planning, companies can identify new opportunities, as well as threats, and find new ways of doing business that can give them long-term competitive advantage.24 © The Economist Intelligence Unit Limited 2011
  26. 26. Appendix The long viewSurvey results Getting new perspective on strategic risk Appendix: Survey results Do you have responsibility for, or influence over, strategic decisions on risk management in your company? (% respondents) Yes, as CEO or other board-level executive 42 Yes, as a dedicated risk executive below board-level 36 Yes, as non-executive director 19 Yes, as CRO 3 When formulating long-term plans for your business, what is the maximum time horizon over which you consider strategic objectives or risks? (% respondents) Strategic objectives Risks One year 8 20 Up to three years 33 36 Up to five years 37 25 Up to ten years 14 11 Up to 20 years 4 3 More than 20 years 3 425 © The Economist Intelligence Unit Limited 2011
  27. 27. Appendix The long viewSurvey results Getting new perspective on strategic risk For the timeframe you selected in the previous question, which of the following issues do you currently take into account in considering strategic objectives and risks? Select all that apply. (% respondents) Strategic objectives Risks Business growth prospects 86 55 Customer demand 74 53 Macroeconomic outlook 70 67 Financing availability 58 54 Fiscal outlook 47 53 Political outlook 46 61 Demographic outlook 45 32 Resource availability (eg water, oil) 25 32 Climate change 17 26 Other, please specify 7 7 What do you see as the value of risk analysis that considers events more than one decade into the future? (% respondents) It is a vital part of the strategy process in our business. 24 We do this, but more as a thought exercise than as part of the strategy process—it is difficult to incorporate it into our strategic planning. 44 We do not do it because we do not believe it has value. 3226 © The Economist Intelligence Unit Limited 2011
  28. 28. Appendix The long viewSurvey results Getting new perspective on strategic risk Which of the following tools does your company use or intend to use to identify and assess long-term risks? Please select one for each row. (% respondents) Currently use Intend to use Do not intend to use Scenario planning 72 19 10 Third-party forecasts 60 19 22 Risk mapping 51 31 18 Horizon scanning 43 29 29 Other, please specify 22 14 63 Which of the following statements best describes your company’s approach to using scenario planning? (% respondents) It is a useful input to helping us formulate and adapt our strategy in uncertain times 46 It plays a vital role in helping us formulate and adapt our strategy in uncertain times 20 It is an interesting thought exercise but does not have a major bearing on our strategy process 18 It helps us to assess the robustness of our business model and strategy over the longer term 7 It helps us better anticipate the unexpected 5 We do not think that scenario planning has any real relevance to our business 4 What, if any, do you consider to be the main barriers that prevent your company from taking a longer-term view of its risk exposure? Select up to three. (% respondents) Executive management is more focused on immediate risks 41 Pace of business is too fast to make long-term risks worth considering 36 Doubts about its risk value 33 Lack of expertise in long-term risk analysis 31 Investor focus on short-term performance means that management does not spend much time on longer-term issues 20 Lack of available tools 18 Lack of time and resources 17 Incentive structures are geared toward shorter-term issues 16 Relatively short tenure of most senior executives 7 Other, please specify 3 We do take a longer-term view of our risk exposure 827 © The Economist Intelligence Unit Limited 2011

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