Cognitive Bias and ERM

Session 12: ERM Process and Analytic Decisions –Risk Messaging

 Quiz 3
 Brief Review: How Value Based ERM Helps Risk
Messaging
 Cognitive Biases in Risk Communications
 Behavioral Issues in Risk Presentations
Agenda
12/1/2020
2
3
HOW VALUE BASED ERM
HELPS RISK MESSAGING
4
Internal
• Risk reporting for
management and board
– Charts, narratives, and
formal presentations
• Integrating risk into
business performance
• Integrating risk into
incentive compensation
External
• Risk disclosures
– Shareholders (e.g. 10-K)
– Regulators (e.g. Basel)
• Earnings calls and Q&A
with stock analysts
• Rating agency info
requests and presentations
• Regulator requirements
and examinations
Forms of Risk Messaging
12/1/2020
3
5
1) Integrating ERM into business performance analysis
– Traditional approaches are suboptimal
• Analyzing prior period results lacks rigor and is incomplete
o Lack rigor
 Risk-adjusted hurdle rate set arbitrarily
 Base to which hurdle rate applied is poorly defined, e.g., equity or
required capital (should be company value)
o Incomplete: ignores actions impacting trajectory of future results
• Balanced scorecard is fundamentally un-balanced
o Weights are arbitrary and improperly value different marginal contributions
– Value-based approach resolves these issues
• Hurdle rate is set rigorously (revised with firm volatility changes)
• Base is appropriately company value
• Focuses actions in proper proportion to potential marginal contribution
Internal risk messaging
6
2) Integrating ERM into incentive compensation
– Stock option plans commonly used
• Information mismatch for award value – actual stock price
• Poor metrics used for award amount – traditional performance
– Value-Based ERM solves both problems
• Phantom stock using baseline company value for award value
• Change in baseline company value for award amount
3) Management and Board Reporting
– Updates on exposures, opportunities and emerging risks
– Approvals of risk appetite, limits, and mitigation plans
Internal risk messaging (continued)
12/1/2020
4
7
 Shareholders
– Voluntary risk disclosures (potential competitive advantage?)
– Mandatory risk disclosures
• Risk factors (Form 10-K, Item 1A)
o SEC required “discussion of the most significant factors that make the
offering speculative or risky”
• Risk governance
o SEC requires info on board’s role in risk oversight
• Risky incentive compensation programs
o If it creates risks “reasonably likely to have a material adverse effect”
 Stock analysts – Conversations about potential risks
– Explain internal valuation model with “what-if” capability
– Outline relevant risk scenarios analyzed and businesses impacted
– Describe mitigation actions put in place
– Highlight any differences from analyst estimates of risk impact
External risk messaging
8
 Rating agencies / bondholders
– S&P
– Moody’s
– Fitch
– AM Best (insurance only)
– Kroll Bond Rating Agency
 Regulations from financial crisis
– SEC: Feb 2010 rule:
• Disclosure of risk governance, board role in managing risk
• Disclosure of all compensation if it creates risks reasonably likely to
have material adverse effect
– Bank regulators: stress tests
– Dodd-Frank
• Financial Stability Oversight Council
o SIFI oversight/restrictions
External risk messaging (continued)
12/1/2020
5
9
COGNITIVE BIASES IN
RISK MESSAGING
10
• Social and cultural pressure
• Professional background
• Education
• Motivations as to perceived success or failure
• Emotions
Factors Influencing Cognitive Bias
in Risk Messaging
12/1/2020
6
11
 Normalcy Bias – Minimizes threat warnings and
downplays disaster and its impacts
– “It’s business as usual. Nothing to worry about.”
 Familiarity Bias – Categorizes new experiences or
situations along the lines of the familiar rather
than evaluating them more deeply
– “Catching COVID is just like getting the flu.”
 Confirmation Bias – Cherry-picking the
information to share to fit expectations
Common Biases in Risk Messaging
12
 Narrative Fallacy – Creates a cause and effect
relationship where none exists
 Overconfidence Bias – False sense of one’s
ability to accurately identify and manage risks
– “We’ve got this under control.”
 Hindsight Bias – “I knew it all along.”
– Creates false sense of predictive ability for risk events
Other Common Biases in
Risk Messaging
12/1/2020
7
13
 Acknowledge cognitive bias existence
– Practice actively searching for biases in messaging
 Leverage and enhance ERM information
– Let the facts drive the narrative
 Surround yourself with multiple viewpoints
– Diversity of experience, expertise, and worldview
 Research and test risk messaging
– Utilize framing bias to increase effectiveness
Mitigating Bias in Risk Messaging
14
BEHAVIORAL ISSUES IN
RISK PRESENTATIONS
12/1/2020
8
15
Impact on Speakers
• Impede objective
reasoning
• Lower confidence levels
• Inhibit effective delivery of
risk message
Impact on Audience
• Skewed perception of
speaker
• Unintended interpretation
of risk message
Implications of Behavioral Issues
in Risk Presentations
16
 Spotlight Effect – Obsessed with being judged by
the audience
 Planning Fallacy – Overstating risk management
plans and their effectiveness
 Curse of Knowledge – The risk presenter
assumes the audience knows what he/she knows
Behavioral Issues in Risk Presentations
12/1/2020
9
17
 Style over Substance – Overemphasis on the
visuals with lack of a meaningful message
 Courtesy Bias – Saying what the audience wants
to hear instead of what they need to hear
 Imposter Syndrome – Concern that message will
not resonate due to (lack of) status of presenter
More Behavioral Issues
in Risk Presentations
18
 Awareness of audience preconceived ideas
 Awareness of one’s own preconceived ideas
 Control nervousness – take 3 deep breaths
periodically
 Solicit feedback
Minimizing Behavioral Issues
in Risk Presentations