Considering its inherent complexity, enterprise-wide scope and financial significance, strategic risk is an executive-level issue at its core. It’s so vital that five of the world’s leading finance and accounting organizations developed a consortium to build an integrated framework for enterprise risk-related decision-making.

The Committee of Sponsoring Organizations (COSO) of the Treadway Commission—jointly sponsored and funded by the American Accounting Association, American Institute of Certified Public Accountants, Financial Executives International, Institute of Management Accountants and Institute of Internal Auditors—has been tweaking its model enterprise risk management tool for more than a decade. While the model has a sound framework with five components and 23 principles, it contains considerable challenges to effective implementation. The biggest obstacles for most businesses have been accurately quantifying, tracking, aggregating and reporting risk throughout their complex organizational structures; in other words, the analytic side of risk management. 

The nature of risk, broadly defined by COSO as “the art and science of choice,” demands quantitative and qualitative management. An in-depth quantitative analysis focuses, shifts and strengthens the qualitative aspects of risk management. Qualitative aspects include much of the COSO framework and its implementation: the unique and dynamic combination of risk preparedness, control, retention, leverage, diversification, distribution and transfer. For visionary executives looking to gain foresight and position their organization for maximum stability and financial strength, comprehensive quantitative risk analysis is the yin to the yang of qualitative risk management.

Performance Metrics Don’t Measure Up
Strategic risk management entails understanding—and managing—the likelihood, frequency and impact of future events on the organization’s financial strength. As such, it is inextricably linked with everything that drives the firm’s financial performance. Most companies track key performance indicators (KPIs) to measure and analyze risk associated with specific activities, processes and objectives, and then drive action to impact those areas being measured. Performance metrics may be a vital part of any quantitative effort, but they are inherently fraught with shortcomings.

KPIs tend to devolve from a measure to a target to be achieved. Silos get built around the targets, and their pursuit too readily supersedes the overall organizational good. Also, KPIs tend to be of limited use in comparing risk profiles of competing strategic opportunities. Further, with KPI analysis, there is no formal process for the early awareness and identification of the evolving risk landscape related to technology, regulations, markets, the organization itself and countless other factors.

Because real-world organizational dynamics don’t occur in isolation, this oversimplified “islands of analysis” approach complicates what it intends to clarify. The common result is lost organizational value; typically, the larger the organization, the greater the losses.

Predictive Risk Modeling
Even when companies manage to minimize the pitfalls of performance metrics, a higher level of analysis offers a significantly enhanced perspective and added strategic value. New technologies and advanced analytic techniques are empowering more organizations to identify and assess the full scope of threats and opportunities impacting them—their unique and ever-changing risk portfolio. From there, improved strategies for competitive advantage are being implemented by companies at the mid-market level as effectively as their larger competitors.

Insurance companies and investment firms have used risk modeling techniques for years in portfolio analysis. They are now being used to evaluate, predict and effectively manage organizational risk.

COSO offers its perspective: “With a portfolio view, management is well-positioned to determine whether the entity’s overall risk profile aligns with the risk appetite. The same risk across different units may be acceptable for the operating units, but taken together may give a different picture. And in cases where the portfolio view shows that risks are significantly less than the entity’s risk appetite, management may decide to motivate individual operating unit managers to accept greater risk in targeted areas, striving to enhance the entity’s overall growth and return.”

Quantitative strategists use time-tested approaches that incorporate sound business principles, extensive research and real-world complexity to build organizational risk portfolios. The power of automation technology and techniques—such as financial modeling, time-sensitive profiling, normalization, correlation and regression, and predictive modeling—empower executives to leverage their experience, instincts and intellect with objective in-depth analysis to improve quality, reduce the cost of risk and enhance enterprise value. Beyond taking inventory, risk modeling fosters an enhanced understanding of the full implications of a strategy.

Clarity From Complexity
In broad terms, quantitative strategy is simply a way of measuring relationships. In narrower terms, this strategy includes a set of grossly underutilized techniques that leverage research, measurement and financial modeling to evaluate the behavior of specific variables based on other variables that are determined through analytic techniques proven to impact them.

Quantitative analysis can get quite “nested” (i.e., analysis of relationships within relationships) and more than a little dry in detail, but its principles and application are relatively simple to comprehend and communicate. By representing the analysis visually through a dashboard application as a best practice, an intuitive picture of the organization’s comprehensive strategic risk profile can be quickly understood, shared and drilled down—from enterprise-wide strategic planning through business-unit “what if” cost-benefit forecasting, down to performance management in each functional area of the organization.

In other words, quantitative analytics cut through the complexities of risk to give executives an understanding of what areas are having the greatest impact on their business’s financial strength, how the business is trending, what is impacting the business (and to what degree) and how its future looks given various decisions the organization could make.

Through risk modeling and profiling techniques, executives can strategically transform the organization from monitoring limited KPIs to regularly reviewing an actionable dashboard and proactively managing a predictive risk management program that cuts through the complexity of enterprise risk, adds significant financial value and strong opportunity for sustainable competitive advantage. 

Tony Wernke is a risk management advisor and quantitative strategist. For more information, email twernke@gmail.com.