How to measure the immeasurable

Andrea Felsted examines the range of options available to businesses but finds there is no substitute for common sense

Just as companies today face myriad risks to their operations, so they can choose from a wide range of tools to help them identify, measure and control the threats they face.

Such instruments range from tools that rely on complex mathematical and statistical analysis, to those which are very subjective, such as web-based systems that enable a company to canvas the opinions of its staff around the world on subjects such as stress in the workplace.

As particular hazards come to the forefront of companies’ and insurers’ minds, so risk management tools are being adapted to meet their changing needs.

Oliver Peterken, a director of Willis, the insurance broker, says that since the World Trade Center attacks three years ago, catastrophe modelling is increasingly being applied to man-made disasters.

Previously, the technique, which uses computer programmes to estimate the impact from potential disasters, was used mainly to calculate losses from natural catastrophes, such as hurricanes.

“In terms of people’s focus, I would say it has gone from 100 per cent natural and nought man-made. It is probably now 70/30,” says Mr Peterken.

Despite the startling array of tools available, Eddie McLaughlin, head of business risk consulting at Marsh, the insurance broker, points out that the decision on which tool to use is dictated by the particular business and issue at hand.

For example, a bank looking at how much capital to set aside against a particular risk would require a very mathematical approach.

But a company considering relocating a manufacturing plant would need to take in the views and opinions of executives involved in the decision on what the key risks might be.

In order to reach a consensus in such a situation, Mr McLaughlin says management could use a voting keypad enabling executives to elect the level of threat they attach to different hazards.

But some threats, such as shifts in competition or damage to a company’s reputation, are less tangible and much harder to measure.

In the face of such risks, suitable tools would feature scenario analysis.

This enables managers to establish a range of different outcomes depending on various decisions and actions.

FM Global, a commercial and industrial property insurer, believes the majority of all loss can be prevented or minimised.

It eschews mathematical modelling in favour of repli­cating full scale warehouse fires, floods and explosions at a purpose built research campus.

These insights can then be used to develop initiatives to prevent or minimise losses.

Paul Taylor, a spokesman for the Association of Insurance and Risk Managers, agrees complex tools might not always be the answer.

What is needed, he says, is an understanding of how likely a particular event or hazard is to occur, and what its impact would be, either financially, or in terms of damage to a company’s reputation.

The impact should be evaluated at two levels: a worst-case scenario and a best case scenario with all possible risk mitigation measures in place.

The effects of either situation can then be presented graphically on a simple risk map or matrix.

The vertical axis represents the probability of an event occurring, and the horizontal axis the impact. Each segment in the grid would represent a certain level of impact.

“It is an awful lot of common sense. It is not rocket science,” says Mr Taylor.

But such an approach “enables someone to look at the risks and make a quick decision or make a clear decision on whether or not these risks are acceptable given the business environment and context”.

An array of sophisticated tools however does not negate the need for more down-to-earth thinking.

“These tools are not a substitute at all for judgment or common sense,” says Mr McLaughlin.

Nor should the conclusions of a sophisticated modelling tool be accepted without question.

“Everyone has heard of garbage in, garbage out. There is also garbage in, gospel out. There is a danger that if something has come out of a computer, everyone thinks it is perfection. They attach a greater credibility to the number because there is some substance. It is expected to be precise. But it is better to be roughly correct than precisely wrong,” says Mr McLaughlin.

Instinct also plays an essential part.

The hazards that a company is prepared to live with will depend on its attitude towards risk and also its culture.

But the problem with instinct is that it can sometimes lead to decisions that have more do with managers’ favourite topics than the reality of the business environment.

“The danger with instinct is that there is nothing to back it up,” says Mr McLaughlin.

“The tools get a balanced decision, with some form of justification for your action.”