Well-run companies prepare for the risks they face. Those risks can be significant, and while they’re not always addressed successfully—think Deepwater Horizon, rogue securities traders, and explosions at chemical plants—the risk management function of a company generally helps it develop protocols and processes to anticipate, assess, and mitigate them.
Yet even a world-class risk management system can’t prepare a company for everything. Some risks are so remote that no individual manager or group of managers could ever imagine them. And even when firms envision a far-off risk, it may seem so improbable that they’re unwilling to invest in the capabilities and resources to cope with it. Such distant threats, which we call novel risks, can’t be managed by using a standard playbook.
In this article we’ll explore the defining characteristics of these risks, explain how to detect whether they’ve materialized, and then describe how to mobilize resources and capabilities to lessen their impact.
What Makes Risks Novel
Unlike the more-familiar and routine risks a company faces, novel risks are difficult to quantify in terms of likelihood or impact. They arise in one of three situations:
The triggering event is outside the risk bearer’s realm of imagination or experience or happens somewhere far away.
These kinds of events are sometimes labeled black swans, but they’re not inherently unpredictable. The global financial crisis of 2008, for instance, has often been described as a black swan because most banks investing in and trading mortgage-backed securities were blind to the risks embedded in their portfolios. They didn’t envision a general decline in real estate prices. A small number of investors and banks familiar with real estate and financial markets, however, did anticipate a mortgage market meltdown and earned huge profits by shorting mortgage-backed securities.
Often, unforeseen risks arise from distant events at a company’s supplier. Take the case of a small fire in a Philips semiconductor plant in Albuquerque, New Mexico, in March 2000. Triggered by a lightning strike, it was extinguished by the local fire department within minutes. The plant manager dutifully reported the fire to the plant’s customers, telling them that it had caused only minor damage and that production would resume in a week. The purchasing manager at Ericsson, a major customer, checked that his on-hand inventory of the plant’s semiconductors would meet production needs over the next couple of weeks and didn’t escalate the issue.