3.2 Risks-We-Take – Decision Analysis
Taking risks is the other half of Enterprise Risk Management. We take risks in organizations when we make[1] decisions – i.e., we choose alternatives or a combination of alternatives. Whereas events are the focus of risks we face, alternatives are the focus of risks we take.
The Board of Directors and CEO take risks when they choose alternatives in decisions such as mergers/acquisitions, partnering, revising the organizations strategy, making major investments, and hiring executives. Operating managers take risks when they choose alternatives for supplier decisions, personnel decisions, operating policy decisions, and new product decisions. When making/taking decisions about which alternative or combination of alternatives to choose, uncertainty in the form of uncertain losses (risks) and/or uncertain gains (opportunities) typically exist for one or more of the alternatives under consideration. It is, in a sense, a misnomer to refer to ‘risks-we-take’ because when making decisions, we are taking an alternative that not only has risks, but also has benefits, costs and opportunities
(uncertain gains). Because losses loom larger than gains to humans[1] (humans are loss averse) we speak of taking risks and hire chief risk officers rather than taking opportunities and hiring chief opportunity officers. We are concerned with our risk appetite (but not so much our opportunity appetite) where risk appetite refers to our willingness to choose an alternative or portfolio of alternatives with risks and where the appetite can be specified with some measure of overall risk or more specifically, an appetite for risk to specific objectives.
“Risk appetite is the amount of risk, on a broad level, an organization is willing to accept in pursuit of value. Each organization pursues various objectives to add value and should broadly understand the risk it is willing to undertake in doing so.” [1]
[1] “Enterprise Risk Management – Understanding and Communicating Risk Appetite”; The Committee of Sponsoring Organizations of the Treadway Commission (COSO) January 2012.
[1] Kahneman, Daniel and Tversky, Amos, “Prospect theory: An analysis of decision under risk. Econometrica 47 263-291.
[1] British English usage often uses the phrase ‘take a decision’ rather than ‘make a decision’. While there is some difference to the British (the former pertaining to the actual choice taken while the later to the decision process – see http://bit.ly/britishtakedecision) American English almost always uses ‘make’ for both the process as well as the choice. When it comes to ‘risks we take’, taking a decision may be more appropriate as it is more suggestive of taking risks.