Saturday, 19 March 2016

‘Nudging’ Meets Enterprise Risk Management?


It is no exaggeration to say that behavioural economics has become mainstream.  With hindsight, this is not really surprising because the assumptions underpinning economic theory have always been regarded as just that: assumptions. 

The key innovation of behavioural economics are the identification of specific circumstances where there are systematic departures from rational decision making and the development of context-specific predictions of behaviour.  Broadly speaking, departures from rational decision making are referred to as ‘biases’ because outcomes are poorer than the optimal outcomes under rational conditions.  These biases may affect preferences, beliefs or decision making.   Box 1 below shows some common types of biases.

Box 1: Sample of Common Types of Biases Affecting Decision Making

Type
Bias
Description
Example of bias in consumer decision making
Preferences
Reference dependence
Assessments are influenced by the reference point for the assessment ― typically the status quo ― or by a fear of losses.  Depending on the context, this can encourage either too much or too little risk taking.
Purchase decisions are driven by alternatives or product features which are irrelevant to the consumer.
Beliefs
Over-extrapolation
Predictions are made on the basis of few observations believed to be representative from which a real pattern or trend is inferred and, as a result, uncertainty is over- or under-estimated.
The quality of financial advice is assessed on the basis of few successful investments even if these could reflect pure luck.
Decision making
Rules of thumbs
Decision making is simplified by adopting specific rules of thumb such as choosing the most familiar and avoiding the most ambiguous.
Products at the top of a list or offered by large companies are selected.


Another innovation of behavioural economics is the notion that it is sometimes possible to address those biases, and thereby enhance outcomes, by making small changes to the environment ― hence the number of books about behavioural economics with the word ‘nudging’ in the title.  I have come across nudging considerations in terms of sales (e.g. how the default option affects customers’ choices) and in terms of public policy (e.g. the introduction of cooling-off periods in financial services). 

One of the key motivating aspects of enterprise risk management is its effectiveness.  This is not just a challenge concerning an outcome at a particular point in time.  The main aspect of the challenge is putting in place a process that drives enhanced effectiveness.  This is an aspect that has not escaped EU supervisors framing risk and capital requirements for banks and insurers in the EU, which require assessments of risk management effectiveness. 

So how could these two meet?  An assessment of risk management effectiveness could seek to identify behavioural biases that affect the management of risk across the business: for example, in terms of underwriting and investments.  Consider again the biases set out in Box 1: which ones could be relevant to risk management?  If we identify the biases that shape risk management, we can also assess their materiality and consider whether there are ways of addressing them through changes in the operating environment.  If you have any thoughts about how these biases, or others, could affect risk management, I would be very interested to hear them.

This post is part of the series "Aspects of Risk Management".  Other articles are available here.  

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