At first glance, innovation and risk management seem like strange bedfellows. After all, innovation is always risky to some extent. But this attitude is based on a misunderstanding of the risk-management function. When properly considered, risk management can help foster a company's innovation agenda by revealing blind spots and areas of underinvestment that threaten the upside of a company's future. Here's a look at strategic risk and how it can drive your company forward.
What is strategic risk?
"It's the big stuff," explains James Lam, a risk-management consultant based in Boston and author of Enterprise Risk Management: From Incentives to Controls. "Strategic encompasses any risks inherent in a company's business strategy, strategic objectives, and strategy execution." These can include consumer demand, legal and regulatory change, competitive pressure, merger integration, and senior management turnover, as well as the risks inherent in initiatives such as market expansion or new product introductions.
How can strategic risk be measured?
Risk itself is not a single number but a range of probable values that fall along a bell curve, Lam explains. Expected performance would be at the peak of the curve (highest likelihood), while worst- and best-case performance encompass the left- and right-most tails, respectively. While there are sophisticated statistical measurements to define this curve, the most basic metric to track is economic capital, or the amount of equity required to cover unexpected losses. For strategic risks, economic capital represents the "cushion" required to support new product launches or potential acquisitions, or to withstand competitive pressure, for example. Once risk is measurable, you can establish a risk appetite statement, which indicates how much risk you are willing to take on in pursuit of the company's goals.
Incorporating risk management into strategic planning
Think of strategic decisions as wagers that bet company resources on new initiatives. A winning bet will earn the "pot" in the form of increased shareholder value, while ill-advised or bad bets will reduce value to the degree invested. But managing risk can nudge the bell curve so that positive scenarios are more likely and negative ones less so. "Taken this way, the optimum risk management profile resembles a call option: limited downside exposure with unlimited upside potential," Lam explains. "The sooner a company recognizes an initiative is in trouble, the sooner it can take corrective action, whether to get the initiative back on track, deploy risk mitigation strategies, or shut it down."
Measuring success
The final piece of the puzzle is continuous reporting of success metrics in order to track performance and provide early warnings of trouble ahead. In the case of innovation, this means monitoring incremental development and measuring inputs and output against your risk appetite. By taking an iterative approach with rapid experimentation and Agile Development, companies can increase their chances of creating successful new products and extensions while at the same time limiting the downside by re-examining initiatives that fall short of expectations.
While many companies look at "risk management" as merely complying with government regulation or industry standards, the most successful ones see risk as part and parcel of strategic success. Companies that manage strategic risk skew the likelihood of a positive outcome in their favor by ramping up initiatives that exceed expectations and spotting potential losers in time to take corrective action.
