by Annette Hofmann and Dave Taylor

Rather than stepping back and considering a risk more generally, risk professionals are often taught to think in terms of established concepts of coverage—in other words, to prioritize the mechanics of risk management. But despite any training they may have, just like anyone else, they’re prone to biased risk perception. To transition from risk manager to the invaluable role of risk leader, risk professionals must overcome these limitations. This article outlines how they can do just that.

Being human often means being flawed and vulnerable.

This is particularly true when it comes to dealing with probabilities and managing risk. Unfortunately, humans generally don’t respond rationally when confronted with either. Here are a couple of probabilities that may surprise you:
• In a group of only 23 people, there is a 50 percent chance that two share a birthday; however, in a group of 70 people, this probability jumps to over 99 percent.
• The odds of dying in an airplane incident in 2020 were 116 times lower than the chances of dying in a car crash—yet many people still choose driving over flying.

This second finding, from the National Safety Council, is especially troubling because it illustrates how people can make safety choices based on minimal information (such as news about major airplane events). Indeed, many deaths from auto accidents could be avoided by good risk communication aimed at educating the public— in other words, by good risk leadership.

Through such leadership, people could learn, for instance, that airplane travel is really the safest way to get from Point A to Point B in today’s world. And they could understand why it is generally safer not to change travel plans after major events like floods, earthquakes, airplane crashes, near misses, or other catastrophes involving airplanes.

Recognizing Biases

All of us are subject to many biases in risk perception.

For instance, we tend to significantly underestimate the probabilities for natural causes of death, like cancer, stroke, or heart disease, and vastly overestimate the probabilities for unnatural causes, like accidents or homicides. These findings suggest that we tend to give more attention to worrying about unnatural dangers and not enough to natural ones—a bias that’s not easily addressed.

An abundance of evidence1 indicates that people readily eschew statistics in favor of judgment based on more individuated features of events. As a result, and confirmed by psychological studies, we’re often falsely overconfident about our ability to manage risks—a phenomenon that persists even after years of professional training.

Rather than focusing on how to efficiently, rationally, and impartially consider risk, training for risk professionals is mostly devoted to the mechanics of risk management, like ratings or categories to classify risks. But in today’s complex world, this isn’t enough. Unlike risk management, risk leadership recognizes that leaders are often expected to guide the company through tough times or retain certain risks. Part of this responsibility includes
addressing major risk exposures, anticipating opportunities toavoid risks, and implementing risk-related strategies to ensure company survival and long-term success.

Crucial to these efforts is understanding human emotions; aspects of psychology and risk perception; and, accordingly, risk perception-related behavior and its consequences. Many leaders don’t fully understand or aren’t fully aware of how human emotions respond to risk and the cognitive biases they face. In short, above all others, risk professionals should be thoroughlytrained as risk leaders.
Embracing Risk Leadership
So how can we embrace risk leadership? First, we must recognize the tendency for all people, even trained risk professionals and advisers, to make assumptions about risks rather than properly identifying and measuring them. Next, we can realize that because these assumptions are subjective and biased, they can be misleading—whereas measurements and statistics are objective and can’t easily be manipulated.

Risk professionals often use risk maps or ratings to classify and evaluate risks so that they can, in turn, best manage them. Risk leadership goes beyond mastering the typical risk management cycle to involve both qualitative and quantitative aspects of dealing with risk.

On the qualitative side, risk literacy can be a powerful skill for overcoming biases and misperceptions regarding risk. Let’s discuss some major aspects of decision-making that can promote risk literacy, thereby helping risk managers become risk leaders.

Secondary Risk Effects

Avoidance or mitigation of one risk can create another risk. When this happens, risk communication is critical to preventing detrimental, counterintuitive outcomes. This insight implies that secondary effects of risk avoidance should be considered.

For example, assume that the manufacturer of a product being sold in the U.S. recently experienced a small explosion at its headquarters, leading to worker injuries and other costly consequences for the business. After determining that one of the product’s parts caused the explosion, the company decides to stop producing the part and to import it, instead, from a Chinese supplier. Is this a wise decision?

While this move avoids the risk of another explosion, it introduces different risks: most notably, the risk of the part being defective due to loss of control and the risk of non- or not-in-time delivery—in short, a supply chain risk, complete with liability risk and other potential concerns.

An alternative could’ve been simply to employ good risk communication. Specifically, the company could’ve informed employees about the small risk of explosion. And at the end of the day, this would’ve probably been a superior risk-mitigation strategy for the company.

There are numerous examples of secondary risk effects. A recent, real-life example involves precautions taken as COVID-19 became widespread. While quarantining during that time helped mitigate spread of the disease (particularly before vaccines were available), people suffered in other ways—sometimes severely. In some
cases, the lack of face-to-face interaction exacerbated anxiety, depression, and feelings of loneliness. Others found themselves falling behind academically. On the flip side of this coin, however, precautions taken and, later, vaccines administered saved countless lives.

Risk professionals are also humans and prone to a variety of wired-in cognitive mistakes in the way they interpret and react to risk-related information. This is highly consequential in their professional careers since the cognitive mistakes most managers make in their day-to-day business activities erode the objectivity of their risk-related decisions—which ultimately hurts the financial well-being of their firms.

Framing Effects and Use of Heuristics

As humans, we are easily influenced by our environment and the choices presented to us. The framing effect pertains to the way risk-related information is portrayed and how this distorts optimal decision-making.

The resulting process, known as availability heuristic or information availability, is fueled by our tendency to use
information that comes to mind quickly and easily when making decisions. Studies show that framing effects are more common in older adults with limited cognitive resources, as they favor information that is easily accessible.

Framing is an important tool for people who are trying to decipher risk-related information. But often, negative risk-related information ends up being ignored—when it should most definitely be considered.

For example, research on investment behavior suggests that investors check the value of their portfolios less often in bear markets.2 (Indeed, why should I spoil my day by looking at my declining stock portfolio value again?) But people operating in investment or risk prevention contexts benefit most by obtaining all available information. By pairing positive and negative information when updating clients, risk professionals can become better risk managers. And by knowing when and how to approach their clients with all types of information, risk managers can develop into risk leaders.

Reference Points

An important finding in experimental studies is that people tend to make decisions based on reference points.3 Such reference points can vary depending on factors including a person’s wealth, level of risk tolerance, income, and more. However, in some instances, like games of chance, these factors become irrelevant, with unmatched people sharing the same reference point.

For example, imagine sitting at the blackjack table of a casino with Brian, a wealthy man, and Tom, a man living on a low income. Theoretically, Brian should not be as upset as Tom if he loses a hand, because he has plenty of other funds, and he shouldn’t be as happy if he wins a hand, for the same reason. This view takes into account the decreasing value of additional income on wealth.

Yet, in reality, Brian will likely experience the same amount of joy or sorrow as Tom. But why?

It’s because their shared psychological reference point is where they started their casino day. For instance, maybe both put in $1,000 as play money for the day. If so, that’s their reference point, not how any gains or losses affect their overall wealth situation.

If reference points weren’t a factor in this scenario, Tom would be tremendously more affected by the outcome of the game than Brian. But because they are, he’s not.

Communication in Risk Leadership

Communication can best be characterized as the transmission of a message from a sender to a receiver in an understandable manner. The importance of effective communication is immeasurable in the world of business and life in general.

From a business perspective, especially when dealing with risk, providing clear and accurate information that enables leaders to make informed decisions is essential. In “The Art of Communicating Risk,” authors Ann Cleaveland, Jessica Cussins Newman, and Steven Weber note that “firms will never be able to reduce uncertainty to zero, but they can commit to engaging with customers around uncertainty in systematic, predictable ways.”4

Uncertainty poses a major hurdle when dealing with risk communication and often causes poor decisions—or even no decision at all. It’s human nature to want to reduce uncertainty and focus only on the certain outcomes of any given decision. This human tendency, called zero-risk bias, manifests itself in many ways, but we must be more actively aware of it in business decisions.

For example, as risk managers, we must be careful not to allocate resources to a task or project that completely eliminates a given risk if other projects allow for a more efficient use of the firm’s resources. As consumers, we should avoid purchasing full insurance if it’s unnecessary and/or overpriced.

What can we learn from these insights? Well, when it comes to risk, competent decision-making and communication require training and practice. This is especially true for people who frequently handle risk, as they need to be aware of and strive toward risk leadership.

Sometimes, however, components of insurance and risk mitigation training can actually impede risk leadership. For
instance, while companies may be tempted to treat single risks by seeking affordable coverage or selecting a risk mitigation technique, this action may distract them from maintaining a holistic view of the overall corporate risk exposure.

What’s preferable is adopting a portfolio approach that balances risk reduction and the costs of risk reduction or avoidance. Think of an investor who doesn’t care if one stock goes up or down, only about the overall portfolio’s performance relative to the investor’s initial investment.

Corporate risk exposures are often insurable—but when they’re not, the risk-mitigation or risk-financing strategies need to be reevaluated. In fact, the common strategies of managing/addressing/transferring risk can complicate leading in the acceptance of risk, thereby requiring competent risk leadership.

Fortunately, we can all become better communicators by following an effective communication process, made up of four key components: encoding, medium of transmission, decoding, and feedback. Critical to this process are two factors: the sender and the receiver.

The sobering reality is that we’ll never be able to find complete certainties in our decision-making process. However, the more we understand about how to communicate, the more likely we are to reduce miscommunication—and, in turn, to achieve better outcomes.

Sources:
1. See Annette Hofmann, The Ten Commandments of Risk Leadership (Cham, Switzerland: Springer, 2022). Also see John Beshears and Francesca Gino, “Leaders as Decision Architects,” Harvard Business Review, May 2015.
2. See Hofmann.
3. See Hofmann; Beshears and Gino.
4. Ann Cleaveland, Jessica Cussins Newman, and Steven Weber, “The Art of Communicating Risk,” Harvard Business Review,
September 24, 2020.