Using Probability Charts for Risk Reduction

Instructor: Scott Tuning

Scott has been a faculty member in higher education for over 10 years. He holds an MBA in Management, an MA in counseling, and an M.Div. in Academic Biblical Studies.

All strategic decisions have risks associated with them, but not all risks are equal. This lesson outlines ways that decision-makers can systematically characterize risks in order to focus the right resources on the right risks.

All Risks Are Not Created Equal

Imagine that you own two homes. You spend the winter in the Florida Keys and the summer in a nice, secluded cabin in Idaho. When you purchased your homes, you had to choose an insurance policy that would protect you from loss in case your homes were to be destroyed. Unfortunately for you, flood insurance, and in some cases wildfire insurance, have to be purchased separately and are more costly than other forms of insurance.

Would you pay the extra money to obtain flood insurance on your cabin in Idaho and wildfire insurance for your home in the Florida Keys? Probably not, but why not? It's a silly example, but it's actually relevant to risk management and strategic decision-making. It's not very likely you would purchase flood insurance for a cabin in an area that has not seen a flood in more than 100 years, nor is it likely you would purchase wildfire insurance for a home that sits on the beach. Of course, the reason you would not purchase these products is because the probability that you would suffer loss as a result of these conditions is relatively low.

On the other hand, you probably will purchase flood insurance for the home in Florida, and wildfire insurance for the cabin in Idaho, because the probability in that scenario is much higher than in the previous one. Although you made this risk assessment in your head, in more complex scenarios with more variables, decision-makers can use a risk/probability matrix in order to help them determine which risks warrant the most attention and resources.

Managing risk is essential to successful strategic decisions.
Fig1

The Matrix

In its most simple form, a risk probability matrix is a square divided into four smaller squares. Each square corresponds to a different combination of the risk's probability and potential impact. The matrix is designed to guide strategic decisions by focusing resources on adverse events that are both likely to occur and would be very serious if they did occur. As a result, the matrix helps decision-makers place the highest priority on events in the high risk, high probability category and the lowest resources in the low risk, low probability square.

Balancing Complexity and Simplicity in the Matrix

Not all risks can be quantified in numbers, and not all probabilities can be known scientifically. For this reason, a risk probability matrix must strike a balance between being complex enough to take into account all the necessary risks, but simplistic enough that it remains a useful tool for decision-making. One of the ways an organization or a strategic decision maker can build and utilize a solid matrix is by conducting a SWOT analysis.

A SWOT analysis is a tool that organizations use to take a snapshot of their current environment and compare it to their long-term goals. The first part of a SWOT analysis is an evaluation of strengths and weaknesses, and the second part is the evaluation of potential opportunities and threats. Let's apply this tool to your houses in Florida and Idaho to demonstrate how the SWOT analysis can help build a reliable risk/probability matrix.

Starting with strengths and weaknesses, we would begin by simply establishing that the home in the Florida Keys has a strength in being somewhere in which there are no wildfires, but a weakness in that it exists in a place where flooding is common. Obviously, the inverse is true for the Idaho cabin.

Applying the opportunities and threat analysis to the house example yields a similar result. The greatest threat to the cabin in Idaho is a fire, not a flood. In terms of opportunity, you have the opportunity to save money by purchasing only the insurance you need on each home based on the probability that one or both would be destroyed in a particular manner.

Using the Matrix to Make Better Decisions

The purpose of this matrix is not merely to identify these risk features. Rather, it is to provide strategic leaders with the opportunity to reduce the likelihood that the threats would materialize and harm the organization. In the example of the two homes, your matrix allows you to reduce the risk of losing both of your homes by focusing resources on protecting them from the most likely threats they face.

The matrix can help an organization minimize risk.
Fig2

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