Risk management can be defined as the culture, processes and structures directed towards realising opportunities whilst managing adverse effects. An explanation for the increased interest in risk managament is the opportunity to apply new thinking and tools on the “new risk reality”. We believe risk management should be an integral part of good business practice at both a strategic and operational level.

The core of risk management is to assess the uncertainty of the future in order to make the best possible decision today. All risk management and all decision-making deal with this general issue. The benefits of risk management are the benefits of better decisions; fewer surprises, improved planning, performance and effectiveness and improved relationships with stakeholders.

The new risk reality
Is the world a riskier place than before? Many say yes, pointing to climate change, terrorism, pandemics and an almost endless list of other threats. For those of us in business, we just need to think about Andersen the auditors who was “the gold standard” within their profession and then disappeared within months, innovations like the iPod, Napster and Google that create or reshape whole industries. Risks are increasingly caused not by nature, but by new technologies and human acts.

On the other side, life has certainly become less risky in important ways for people in may countries. Over the past century life expectancy has risen by two thirds, we have cures for more diseases, workplaces and the wider environment have become less hazardous, , and we can insure ourselves against the financial consequences of more risks.

Riskier or not, the risk picture is changing. DNV has coined the term “the new risk reality”. By this we want to point out that:

• Companies today are operating in an increasingly global, complex and demanding risk environment
• Society at large is gradually adopting a “zero tolerance” for failure. There are stricter regulatory requirements and increased demands for transparency and business sustainability
• New technologies have benefits – and introduce new risks.

Advances in risk management thinking and tools
Over the last decades, there have been a number of significant advances in risk management. Within finance and markets, important advances include portfolio selection and optimisation (Markowitz), option valuation (Black & Scholes), later extended to real options, and value-at-risk. These are all quantitative techniques for understanding and analysing risk. Finally, a number of new markets for risk transfer have emerged.

Many of these concepts would be impossible to implement without the increase in computing power, especially the capacity to deal with simulations and massive data volumes and time series.

A third area where we have gained better insight into risk management is “the mind of the decision maker”. When organisational decision making first was introduced as a concept, the search was for the optimal decision. This proved difficult to find, and Herbert Simons “bounded rationality” – i.e. taking “good enough” decisions within the constraints of time, complexity and limited mental computational power became the dominant paradigm. Later, Kahneman and Tversky demonstrated that the rational decision assumed in economics simply does not describe how people actually make decisions under uncertainty. Prospect theory has identified factors that can lead us to decide against our economic interest even when we know better.

Better decisions, but not always better outcomes
Although good risk management will contribute to better decisions, this does not always translate to better outcomes. The term “risk management” can give the impression that – given enough analysis - it is possible to get a sufficiently complete picture of the future. That is wrong and misleading. Think of attempts to predict the oil price, house prices, financial volatility – or the winner of the football world cup. Given the limitations of risk management the ability to respond must be developed.