Developing and Monitoring Early Warning Indicators

There is an old saying that it takes twice as much information to change a forecast as it does to originally form it. This gets to the heart of a critical source of strategic risk governance failure -- insufficient updating over time of both a company's initial assessment of the likelihood of key risks materializing (including the potential impact of their various interactions), and the size of its exposures if they do.

A range of individual and group psychological factors and processes account for these updating failures. At the individual level, we are naturally both overoptimistic (i.e., we tend to overestimate the level of the most likely outcome) and overconfident (i.e., the probabilities we attach to our estimates being correct is usually higher than the actual outcome). We also tend to choose people with these characteristics as group leaders.

In addition, we naturally try to maintain a coherent view of the world, and consequently pay less attention to, and underweight, bad news and information that does not fit well within our existing mental model of a system or situation.

Moreover, when the fear center of our brain (the amygdala) is triggered by rising uncertainty or actual loss, our aversion to social isolation also rises, making us more likely to conform to the views of a group, and to resist voicing our concerns with where it may be headed. This tendency is further reinforced by a strong human desire to avoid errors of commission (false alarms), even though that necessarily increases the risk that we will make errors of omission (missed alarms). Unfortunately, researchers have found -- as have too many directors at failed companies -- that over anything longer than a short-term time frame, missed alarms are frequently far more costly than false alarms.

At some point in the evolution of the human species, all of the tendencies noted above were undoubtedly adaptive, and helped to ensure our collective survival. Unfortunately, that is often not the case in today's more complex, fast-changing, and uncertain world. And to compound our predicament, research has repeatedly shown that, even when a management team is made aware of these cognitive and behavioral tendencies, they are still extremely difficult, and often impossible, to overcome.

All of these factors make the board's role critical in governing strategic risk, and effectively monitoring the early warning signs of potential company failure.

But how is a board to do this? In our experience, the solution lies not in trying to change human nature, but rather in changing information flows, structural processes, and methods, to enable the board to more effectively offset the natural tendencies of the management team.

For the same reason that intelligence agencies frequently employ the so-called "Red Team/Blue Team" or "inside/outside" approach, boards and directors can also benefit from having independent outside advisors track and regularly report on the continued validity of key strategic assumptions, the evolution of critical strategic uncertainties, and emerging sources of existential risk, just as they benefit from the use of outside auditors to validate their financial reporting and internal controls. Both provide a structural check on natural human tendencies that can easily lead to corporate crises and failure.

Britten Coyne provides boards and management teams with ongoing independent assessment and reporting on the evolution of key assumptions, critical uncertainties, and early warning indicators. For more information about this service, please contact us.