How risk leadership leads to better, more rational decisions

Authors:

• Bhavik Modi, Senior Director, Innovation and Digital Transformation at BTS
• Dr. Annette Hofmann, Director of the Lindner Center for Insurance and Risk Management at the University of Cincinnati, author of The 10 Commandments of Risk Leadership, and Editor-in-Chief of the Risk Management Insurance Review (RMIR).

Dr. Annette Hofmann is a researcher, author, and leading expert in the field of organizational risk. In this interview with Bhavik Modi, Senior Director, BTS, Dr. Hofmann explains how moving beyond a traditional approach to risk and developing risk leadership competence can help companies become more resilient and profitable—and may even save lives.Bhavik Modi: Dr. Hofmann, I’ve been fascinated to explore your research into risk in relation to the healthcare and insurance markets, and to industry in general. Under your leadership as director, the Lindner Center for Insurance and Risk Management is doing fantastic work in researching and collaborating with industry. BTS is excited to be partnering with the center on a new course based on your research. Thank you for agreeing to discuss your insights with me.Modi: I’d like to start with defining terms. Organizations have traditionally focused on risk management. How is this different from risk leadership?Dr. Annette Hofmann: Speaking specifically about the insurance industry, risk professionals are typically trained to think in terms of established concepts of coverage—additional insureds, medical payments, etc. They use risk maps or ratings to classify different risks and then evaluate them to find an appropriate risk-management technique. They focus on the mechanics, the quantitative aspects, of managing risk.Risk leadership addresses not just the quantitative but also the qualitative aspects of dealing with risk. This requires risk literacy. Understanding individual risk perception, risk aversion, risk perception-related behavior, and how emotions respond to risk and the cognitive biases that result is crucial to developing the risk literacy that enables better decision-making. This understanding is especially important for leaders, as their decisions have greater consequences. Risk leadership also requires communicating about risk, providing direction and guiding the company through tough times by coordinating efforts to deal with major risk exposures, anticipating opportunities to avoid risks, and implementing a risk-related strategy to ensure long-term success.Modi: Often, risk leadership is associated with the insurance or actuarial professions. How can this concept be applied to organizations in other industries?Hofmann: Many new titles have emerged in the past decade—Chief Risk Officer (CRO), Director of Risk Management, Vice President Risk Services—demonstrating a broad recognition that risk management deserves to be a top priority. The challenge is to move from competence in risk management to true risk leadership.In The Leader’s Brain, Wharton Neuroscience Professor Michael Platt describes how key areas in our brain work and how insights from this can be used to teach us how to develop better leadership abilities. He writes that while it’s difficult to train people in some areas, such as ethical decision-making, improvements in risk literacy are relatively easy to accomplish. The task consists mainly of acquiring knowledge about the risk-related biases our brains are commonly exposed to and gaining insights into how these biases can be avoided. Understanding the hidden forces that drive our decision-making processes under risk and uncertainty, we can be trained to make more rational decisions.Modi: What is the “uncommon sense” when it comes to risk leadership? What behaviors are well understood but often not put into practice? Or which behaviors are counterintuitive to how we would traditionally think and work?Hofmann: Managers are often seen as having sophisticated information-processing capability, as being able to make rational risk-related decisions based on economic incentives and the fullest available range of information. But managers are human beings, and like all of us, prone to biases and cognitive mistakes when they interpret risk-related information. These mistakes, together with emotions, hinder the objectivity of their decisions, which ultimately may hurt the financial survival of their firms.For example, the lack of objectivity prevents managers from identifying and taking into account secondary risk effects, which is when avoiding or trying to mitigate one risk creates another risk. Risk leadership means not only seeing the potential for secondary risk but also communicating throughout the organization how this is influencing the decision-making process.Consider the case of a U.S. manufacturer that recently experienced a small explosion leading to worker injuries. The company decided, following pressure from employees, to stop producing the part that was responsible for the explosion. Consequently, the part is now being imported from a Chinese supplier. Was this a wise decision? Well, the risk of another explosion is avoided, but now there is a secondary risk: the imported part could be defective; it might be delivered late or not at all. The decision to stop producing the part now creates supply chain risk.Good risk communication, letting employees know about the very small risk of explosion and the firm’s efforts to prevent a recurrence while continuing to produce the part, might have been a superior strategy for the company.Modi: How much of risk leadership is preventive versus reactive? And what are the consequences of poor risk leadership in a reactive or preventive situation?Hofmann: When it comes to reactions, one of the best illustrations of poor risk leadership can be found in the behavior of government officials following the terrorist attacks of September 11, 2001, killing almost 3,000 people.Officials did not provide the public with information about this type of risk that may have headed off a misguided reaction. After 9/11, many people used a car to get to another city or location far from their home rather than taking an airplane. Because driving is so much more dangerous than flying, this switch resulted in an estimated 1,600 more fatalities in the U.S. in the year following 9/11 than would have occurred if people had continued with their previous plans and patterns of travel. Our ability to make decisions based on factual probability data is often influenced by our fears and emotions following big events like the terrorist attacks, and policymakers did not address this effect by communicating potential second-order risk effects to the public.When it comes to preventive risk leadership, people often neglect the potential occurrence of natural disasters by adjusting their subjective probability judgments.People tend to prefer insuring against a high-probability-low-consequence risk such as a bicycle theft, over a low-probability-high-consequence risk, such as a flood. They purchase add-on coverage to the homeowner's insurance policy to cover the risk of bicycle theft rather than covering the risk of loss due to flooding.Studies of insurance demand suggest that individuals tend to ignore or undervalue low probability events.However, after a catastrophe occurs, people suddenly think this will happen again soon and then decide to purchase coverage, which according to probability they are less likely to need the following year. A preventive risk leadership approach would be to inform people about this misguided behavioral pattern and incentivize them to purchase catastrophe insurance before something happens.Modi: It’s clear that developing risk leadership requires a dramatic shift in thinking, including a recognition that, as you say in your book, we are not rational in the face of risk. Change is hard. Why is it worth it for organizations to make this change?Hofmann: Risk leadership enables organizations to identify, and therefore eliminate, the cognitive biases that lead to bad decisions. This needs training and I am happy to help – but of course I am human and therefore my decisions are also far from perfect. Training in risk leadership will lead to better decisions and better communication of those decisions, and ultimately to more profitability and greater long-term success of a company.