Strategic Risk Management
(Slywotzky Drzik)

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What is Strategic Risk Management?

Although Adrian J. Slywotzky and John Drzik of Mercer did not conceive the terminology Strategic Risk Management (SRM), they deserve credit for their excellent description of it in an article in the Harvard Business Review of April 2005. SRM is a technique that can be used for devising and deploying a systematic approach for managing strategic risk, the array of external events and trends that can devastate a company's growth trajectory and shareholder value.

The authors distinguish 7 Classes of Strategic Risk, with underlying subcategories. (some typical countermeasures in italic):

1. Industry
   • Margin Squeeze - shift the compete / collaboration ratio
   • Rising R&D / capital expenditure costs
   • Overcapacity
   • Commoditization
   • Deregulation
   • Increased power among suppliers
   • Extreme business-cycle volatility
2. Technology
   • Shift in technology - double bet
   • Patent expiration
   • Process becomes obsolete
3. Brand
   • Erosion - redefine the scope of brand investment, reallocate your brand investment
   • Collapse
4. Competitor
   • Emerging global rivals
   • Gradual market-share gainer
   • One-of-a-kind competitor - create a new, non overlapping business design
5. Customer
   • Customer priority shift - create and analyze proprietary information, conduct quick and cheap market experiments
   • Increasing customer power
   • Over-reliance on a few customers
6. Project - smart sequencing, developing excess options, employing the stepping-stone method
   • R&D failure
   • IT failure
   • Business development failure
   • Merger or acquisition failure
7. Stagnation
   • Flat or declining volume - generate "demand innovation"
   • Volume up, price down
   • Weak pipeline

Note: Certain financial-, operational-, and hazardous risks can potentially also be of strategic significance.

Origin of Strategic Risk Management. History

The first notion we could find of the term "Strategic Risk Management" is in a paper called "A framework for integrated risk management in international business", By: Miller, Kent D., Journal of International Business Studies, 00472506, 1992, Vol. 23, Issue 2.

Miller describes five "generic" responses to strategic environmental uncertainties, being avoidance, control, cooperation, imitation, and flexibility:

1. Uncertainty avoidance occurs when management considers the risk associated with operating in a given product or geographic market to be unacceptable. For a firm already active in a highly uncertain market, uncertainty avoidance involves exiting, through divesting the specialized assets committed to serving the market. For firms not yet participating in a market, uncertainty avoidance implies postponement of market entry until the industry uncertainties decrease to acceptable levels.
2. Firms may seek to control important environmental contingencies to reduce uncertainties. Managers are here predisposed to trying to control uncertain variables rather than passively treat the uncertainties as constraints within which they must operate. Examples of control strategies include:
   • political activities (e.g., lobbying for or against laws, regulations, or trade restraints),
   • gaining market power, and
   • undertaking strategic moves that threaten competitors into more predictable (and advantageous) behavior patterns.
3. Cooperative responses are different from control responses, because they involve multilateral agreements, rather than unilateral control, as the means for achieving uncertainty reduction. Uncertainty management through coordination is resulting in increased behavioral interdependence and in a reduction in the autonomy of the coordinating organizations. Cooperative strategies for reducing uncertainty include:
   • long-term contractual agreements with suppliers or buyers,
   • voluntary restraint of competition,
   • alliances or joint ventures,
   • franchising agreements,
   • technology licensing agreements, and
   • participation in consortia.
4. Firms may resort to imitation of rival organizations' strategies to cope with uncertainty. This behavior can result in coordination among industry rivals. But the basis of this coordination is clearly distinct from that under control or cooperation strategies. In this case, no direct control or cooperative mechanism is used. Rather, an industry leader is able to predict the response of rivals because their responses are merely lagged imitations of its own strategic moves. Imitation strategies ("follow-the-leader-behavior") involve pricing and product strategies that follow those of an industry leader.
   Imitation of product and process technologies may be a viable low-cost strategy in some industries [Mansfield, Schwartz & Wagner 1981]. But uncertainty about the underlying technology of competing firms may preclude such a strategy [Lippman & Rumelt 1982].
5. A fifth general category of strategic responses to environmental uncertainties involves managerial moves to increase organizational flexibility. Unlike control and cooperation strategies which attempt to increase the predictability of important environmental contingencies, flexibility responses increase internal responsiveness. The predictability of external factors is left unchanged. The most widely cited example of flexibility in the strategy literature is product or geographic market diversification. Diversification reduces company risk through involvement in various product lines and/or geographic markets with returns that are less than perfectly correlated.

Usage of Strategic Risk Management. Applications

• Strategic Planning
• Risk Mitigation and Prevention
• Crisis Management
• Capital Allocation
• Capital Structure

Steps in the Strategic Risk Management Process

1. Identify and assess risks (severity, probability, timing, likelihood over time).
2. Map risks (create a strategic risk map).
3. Quantify risks (in a common measurement currency - i.e. economic capital at risk, market value at risk).
4. Identify potential positive consequences of risks (if company turns the risk into an opportunity).
5. Develop risk mitigation action plans (by risk teams).
6. Adjust capital decisions (capital allocation and capital structure).

Strengths of Strategic Risk Management. Benefits

• Preparation for a major risk enables mitigation of that risk and makes sense to protect company stability.
• If you prepare better for risks than your competitors, who simply manage risks in the "old" way, you have a source of competitive advantage.
• Tool for thinking systematically about the future and identifying opportunities.
• You can turn strategic threats into growth opportunities. Moving from the defense into the offense.
• Probably the benefits of SRM outweigh those of other, less strategic forms of managing risk.
• Avoiding insolvency risks or earnings volatility.
• If you can reduce your GAAP/IAS volatility, this may mean you will have a better standing in the analyst community.
• You can better utilize capital and reduce its costs.
• Organize systems and processes that increase the Risk-Adjusted Return on Capital of the firm.
• Protect corporate reputation.
• Helps companies to fend off additional regulatory and legislative assaults on how they run their businesses.
• Helps corporate executives to defend themselves against legal lawsuits of the sort that have been filed against former Enron, Tyco and WorldCom executives.

Limitations of Strategic Risk Management. Disadvantages

• Strategic risks are just one of four categories of risks (Others are: financial-, hazard, and operational risk).
• Certain risks may occur and cause irreparable damage despite anticipation and preparation ("Acts of God").
• No company can anticipate all risk events.
• SRM is not a box-checking exercise: there are substantial costs and efforts involved to SRM.
• A major potential issue in accomplishing progress with regards to SRM is that in light of Sarbanes-Oxley and other post-Enron developments, companies may likely view SRM as simply another regulation being imposed on them rather than new "ground rules" that, if followed enthusiastically, have the potential to provide global competitive advantage and enhance shareholder value.

Assumptions of Strategic Risk Management. Conditions

• It is possible to prepare for major future risks.
• Preparing is useful.
• It is possible to turn risks into opportunities.

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