Key Risk Indicators - The Crystal Ball of Business
Vice President, Regional Practice Leader – Risk Management (Ontario)
Organizations are generally familiar with the idea of Key Performance Indicators (KPIs). They are measures of how well things are being done and results you have already realized. An example is sales trends, i.e. customer shipments and receivable write-offs over the past month or quarter. On the other hand, Key Risk Indicators (KRIs) are different in that they are an early indicator of emerging risks that could cause harm to the business, such as a macroeconomic shift that could impact customer collection in the future.
When considering KRIs, you can generally put them into two categories:
- Leading KRIs – They are predictive in nature and help to forecast the future.
- Lagging KRIs – They are historical measures and help to identify important trends.
Organizations need a mix of both to provide a full picture of emerging risks.
There are numbers of benefits for an organization to adopt KRIs into their management reporting process. The main one is the ability to monitor potential shifts in risk conditions or new emerging risks. This way, management and the Board of Directors can proactively identify the impact on the organization and take action. In some cases, this could be preventing adverse events from occurring, and, in other cases, could lead to take advantage of a new strategic opportunity. In all instances, KRIs must be viewed within the context of achieving established organizational objectives.
Here are some other key benefits to implementing KRIs:
- They can provide a historical view of risk events so that lessons can be learned from the past and better decisions made in the future.
- They require that management reflect upon and pre-determine their risk appetite or tolerance, and, when reached, trigger action.
- If you are subject to regulatory oversight, KRIs can be used to demonstrate compliance or reduce the chances of fines or penalties. For example, it would be relevant if you have to maintain capital adequacy or reserve levels.
A large retailer is an example of how KRIs can be used. The KRI could consist in negative earnings. A leading indicator on earnings is customer traffic in the stores, which is often driven by the discretionary income levels of the population around the retail locations. Simultaneously, a key metric for discretionary income is oil futures. When the price of oil futures rises, gas prices will also start rising at the pumps. And when gas prices rise, they begin eating a greater amount of a household’s monthly income, leading discretionary spending to decrease, which in turn will lead traffic in stores to decrease as well. By monitoring this KRI,the retailer can get an early indicator of the emerging risk and use the time to modify its sales strategy proactively by adjusting marketing and promotional events and therefore reduce the impact of the risk. When oil futures climb over a certain level, the retailer will adjust its plan to promote more “value” options in the store. When oil futures drop below a certain level (and gas prices are expected to follow), the strategic opportunity consists in adjusting his plan to promote the “premium” options in the store. The key concept is to adjust the plans in advance rather than noticing the impact in the stores. This in turn gives the retailer a better chance of maintaining and smoothing out its earnings.
Here are the typical steps an organization would follow to implement KRIs:
- Make an inventory of all the different stakeholders in the organization, consult with them and ensure that their interests are being considered and addressed in the process. This is a good opportunity to get input and create buy-in.
- Create a balanced selection of performance indicators, lead indicators and trends that tie directly into the organizational objectives. It is often not one indicator that gives you the insight you need; a combination of them will paint the bigger picture.
- Ensure that your KRIs drill down to the root of the event. This way, you ensure that management will have time to respond to the trend.
- Narrow the focus to highly relevant and probable risks so as to not overwhelm the organization. The risks should have a high impact on the organization and be easy to measure.
- Determine the threshold and triggers for each KRI. To ensure the appropriate adjustment to the company strategy takes place, you need to determine in advance your threshold for the risk, at what point the indicator will trigger action within the organization and what those actions will be.
- Locate and find the data sources, within or outside your organization, that will feed the KRIs.
- Determine what notification method will be used within the organization when thresholds and triggers are set off, who the recipients will be and the desired sequence of actions you want to install.
- Train your staff, get their buy-in and monitor the effectiveness.
Business owners, management and Board of Directors transacting in constantly evolving market segments must keep an eye on emerging risks, since events may affect your ability of their organizations to achieve the established strategic goals. KRIs are powerful tools to identify these risks using timely information, to pro-actively manage them within the established risk appetite and to provide reasonable assurance that organizational objectives will be achieved.