As Hurricane Dorian demonstrated last week in the Bahamas and elsewhere, catastrophe can strike without warning with devastating force. How can companies prepare to respond when that happens? Wharton professors Howard Kunreuther and Michael Useem interviewed managers, directors and executives of more than 100 of the largest enterprises in the U.S. In this opinion piece, they explain why some firms have developed creative strategies to reduce the risk of disasters, whether they come from inside or outside the enterprise, while others have not. They provide a checklist for avoiding future disasters. Kunreuther and Useem are authors of Mastering Catastrophic Risk: How Companies are Coping with Disruption (Oxford University Press, 2018).
Firms are coming to appreciate that severe disruptions are hitting them with increasing frequency and strength. They can no longer be treated as rare, black-swan events.
The rising calamities come from outside company walls, as when Hurricane Dorian hit the Atlantic coast last week and terrorists struck New York City and Washington, D.C. in 2001. But they also come from within. Think of the enormous losses for Wells Fargo Bank from its improper lending practices, Volkswagen for falsifying its auto emissions, and Boeing for introducing a fatal flaw into its 737-MAX aircraft.
Still other corporate disasters stem from executive failures to heed signs of looming calamity, as when they missed warnings that signaled the financial meltdown of 2008-2009. The escalating trade war with China and the president’s “order” for American firms to get out may be such a moment as well, challenging firms to respond before it is too late.
By interviewing managers, directors, and executives of more than 100 of the country’s largest enterprises, we have learned why some firms have developed creative strategies to reduce the risk of disasters, whether they come from inside or outside the enterprise, while others have not.
From Intuitive to Deliberative Thinking
Many key decision makers in organizations tend to be overly optimistic and shortsighted by viewing potential catastrophes as below their threshold level of concern. Their intuitive thinking based on emotional reactions to past experience and rules-of-thumb going forward provides a poor platform for preventing debacle.
Little wonder, then, that Wells Fargo executives did not oversee their loan officers when insisting they bolster sales; Volkswagen executives failed to tell their engineers that they could not create illegal workarounds on their diesel designs to keep costs down; and Boeing executives did not insist that their engineers not compromise safety while keeping their costs down.
Deliberative thinking, by contrast, provides decision makers with analytic and systematic methods that better direct a manager’s attention to the forces that lead to the low probability but highly adverse events that no firm can afford. Fortunately, deliberative thinking has been getting the upper hand in executive suites and boardrooms over the past decade. Had directors at Wells Fargo, Volkswagen and Boeing worried more about the risks of draconian executive directives on worker behavior, the three companies might not be struggling with their enormous setbacks now.
When company executives, with board backing, impose tough performance targets on their ranks, as most companies do, deliberative thinking would have helped lead them to consider the danger. A few employees could choose to seemingly “meet” those standards by inappropriate, unethical, or even illegal means, if the tone at the top does not include an explicit and vigorous prohibition of them. Thus, more deliberative thinking could have prevented the unforced errors the three companies committed that led to the suffering by hundreds of thousands.
“Intuitive thinking based on emotional reactions to past experience and rules-of-thumb going forward provides a poor platform for preventing debacle.”
Decision makers at many of the Standard and Poor’s 500 firms that we interviewed reported that they now devote more time and attention to thinking deliberatively, addressing their internal and external risks before they confront them by testing their firm’s resilience at the extremes via scenario analyses and stress testing.
A Checklist for Avoiding Future Calamities
Firms can learn much from their own and other’s adverse experiences. Drawing on our interviews and building on Max Bazerman’s Power of Noticing, Daniel Kahneman’s Thinking, Fast and Slow and Richard Thaler and Cass Sunstein’s Nudge, we have extracted a ten-point checklist from the companies we studied to help others, including non-profits, avoid calamities of their own:
- Recognize that catastrophes are on the rise, and your organization may be next in line. Don’t pretend it cannot happen to you, and instead imagine at least five potential disruptions that could threaten your entire enterprise.
- Correct behavioral biases so firms do not treat threats as below their threshold level of concern. Stretch the time frame for estimating the likelihood of a catastrophic loss, for instance, so that an event that is perceived to have a 1-in-100 chance of occurring next year is instead seen as having a greater than 1-in-5 chance of occurring at least once over the next 25 years.
- Draw on deliberative thinking by defining your firm’s risk appetite and risk tolerance. Systematically balance your risk appetite against your risk tolerance to prioritize management attention.
- Take steps now to invest in protective measures. Design multi-year budgets that spread the high upfront costs of risk-mitigation measures over time so the expected long-term benefits of those investments can be justified now.
- Learn from the disasters and near misses of yourself and others. Take advantage of calamities at companies like Wells Fargo, Volkswagen and Boeing to redesign your enterprise for disaster avoidance now.
- Think long-term. Tying executive pay to multiyear performance-based incentives like stock options can remind those most responsible for company performance of the need for long-term planning.
- Consider worst-case scenarios. Given the great uncertainties associated with low probability risks, firms should consider worst-case scenarios and their likelihood of occurrence over varied timeframes.
- Appreciate global interconnections. Many companies are taking steps to diversify their suppliers and distributors, recognizing that relying on single sources can lead to disruptions, as the auto industry experienced in the wake of Japan’s 9.0 magnitude earthquake in 2011 and the resulting meltdown at the Fukushima nuclear facility.
- Beware of fighting the “last war.” When company leaders believe that the next disruptive event will somehow be like the last one, they are likely to be ill-prepared for a future one. Thinking broadly in constructing future scenarios when conducting after-action reviews will enable firms to overcome the tendency to focus on their most recent adverse event.
- Develop the next generation of risk leaders. Prepare future managers to avoid behavioral biases and bring them into deliberative thinking to guard against the “big one” out there.
In following this checklist, firms can make disaster prevention a source of sustainable advantage, rooted in the well-known mantra, expect the unexpected.
