How CEOs can mitigate compounding risks

Courtesy of McKinsey & Company

By Ram Charan, Celia Huber, and Ophelia Usher

Key takeaways

In today’s complex business environment, corporations face webs of intersecting risks whose combined impact is difficult to predict and manage. When several such hazards materialize simultaneously, the cumulative effect can pose an existential threat to the organization. Such compounding risks are particularly dangerous because management teams tend to underprepare for their combined impact.

Compounding risks are often missed by risk management functions, CEOs, and boards. Yet when unidentified, unmonitored, and unaddressed, they can threaten organizations’ survival. With mounting geopolitical tensions, rapid technological shifts, and other long-term threats that have wide-ranging implications, CEOs need to ensure that their organizations are tracking the interactions among different risks and are prepared for multiple crises striking simultaneously.

Three types of compounding risks

The threat of compounding risks has grown more severe because of the highly interconnected world that corporations operate in today. Often the causes of compounding risks are viewed as black swans, or “unknown unknowns”, that no one could have foreseen, but in most cases the underlying risks can be predicted. To recognize them early on, leaders need to ask which known threats could come together to create a compounding risk that should be considered in their risk mitigation strategies.

Compounding risks fall into three distinct categories: connected, cumulative, and novel risks.

Connected risks are threats to the business from multiple sources that leaders perceive as unrelated but are in fact linked within a broader interconnected system. A single event that disrupts one part of the system can ripple out to other parts. For example, the Russia-Ukraine crisis led to higher cost of raw materials and the loss of international consumer market.

Cumulative risks are one or more risks built over time to trigger a single major shock. The underlying risks are often known to management teams and may even be rigorously monitored. However, the metrics usually only track individual incidents and the thresholds for alerting senior management are set high. As a result, leaders are often unaware that the frequency or severity of these risks is mounting. Social media is a frequent source of this type of compounding risk because a few negative tweets or posts can spread virally, perpetuating a (potentially false) narrative that deeply damages an organization’s reputation.

Novel risk involves multiple known material risks combining to create an unexpected new risk with distinct characteristics. The underlying risks are often long-term in nature, such as the impact of climate change, geopolitical tensions, or technological disruptions.

How to address compounding risks

To take control of such threats, leaders can take four steps: ensure their risk governance program covers compounding risks, validate that their teams are adequately prepared to manage such risks, leverage a horizon approach to investing to ensure long-term vectors of compounding risk are not ignored, and consider compound-risk scenarios when planning big strategic bets.

Strengthen risk management governance.  Leaders should instruct their risk management functions to broaden the scope of the risk scenarios they monitor to include compounding risks. All risks are best tracked through a formal risk management process. It’s critical to establish accountability, with senior executives’ performance scorecards linked to risk management goals and boards regularly updated on how management is preparing for compounding risks. Establishing early warning signals will allow leaders to see how risks are evolving.

Run “premortems” on managing risks. The key to a successful premortem is having a “challenger” mindset and reviewing multiple scenarios in which compounding risks can lead to a crisis. During workshops or executive retreats, futurists and other experts from inside and outside the organization can help the leadership team recognize compounding risks they may otherwise not consider.

Analyzing factors that could produce a crisis can help management teams identify compounding risks and their consequences across multiple time horizons. In such premortem sessions, the team assumes a major negative event (for example, a drastic sales drop), then works backward to imagine how such a scenario might occur.

Use a horizon planning approach. A horizon planning approach can help management teams address risks that can emerge at various stages by looking at three horizons: first, maintaining and defending the core business; second, nurturing emerging businesses; and third, creating genuinely new businesses – which is particularly important to mitigating long-term risks.

Make big bets that address long-term risks. As part of the horizon approach, the CEO needs to make big strategic bets that can fundamentally change the organization’s trajectory. Such investments enable a company to evolve along with its industry and in the process hedge long-term risks by aiming at mitigating numerous threats the organization faces, as industry disruptions are likely to stem from a confluence of risks.

To read the full article, please visit https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/how-ceos-can-mitigate-compounding-risks

About the experts

Celia Huber is a senior partner in McKinsey’s Bay Area office, and Ophelia Usher is an expert associate partner in the Stamford office. Ram Charan is an author and business consultant to CEOs and boards.