What’s A Predictive Indicator?

Thomas Frenehard

For those of you who have been following these blogs, you know that I’m going to address the Analyst drawing out strategy on glass wallspecific topic of key risk indicators (KRI).

As briefly mentioned in a previous blog (GRC Tuesdays – Key Risk Indicators in a Sound Risk Management Process: What Are They Really?), key risk indicators are supposedly forward looking so that they can act as an early warning system. OK, that’s good. But what makes them forward looking?

To me, there are two ways of looking at this and both end at the same result – they need to ensure you receive the information that will help you make the right decision before the risk occurs.

Leveraging predictive models

These types of KRIs make use of mathematical models to provide a future value. For instance, some companies have created their own models to enable digging out a trend on the price of a commodity based on macro and micro-economic indicators.

Consider oil. Some organizations are specialized in providing indicators relative to potential demand per zone based on their production activities, planned extraction volumes, and so on. Combined these could be used to forecast a global trend on prices.

Now let’s take the example of airline carriers. These companies consume a great amount of fuel and this is an important part of the flight ticket price.

Should a company be able to have an indicator related to oil price (like the one mentioned above), it could optimize its tickets’ fare by raising or lowering its price on the forecasted period.

This could not only be a good risk management process because it would reduce the impact of a potential financial loss due to oil price increase, but it’s also a fantastic opportunity management tool as its prices could be more competitive without reducing any of its usual services.

Leveraging current information

It’s not because the key risk indicator doesn’t give you a forecasted value that it means the risk has already occurred. Some indicators can use current information to predict the impact on a risk.

Let’s look again at airline carriers. These companies need to ensure that each flight is profitable or they lose money, which would obviously cast doubt on their business model. One way of preventing this is by calculating the revenue of each flight 24 hours before it departs. Taking into account only the number of seats occupied wouldn’t be sufficient as, if they were all sold at the lowest price, the break-even point might not have been reached.

Now, if the operations manager receives the revenue information 24 hours before take-off, he might make the decision to keep the flight if cancelling it would be more costly. But he could also decide to automatically re-book travelers on flights before or after and give them the option to opt out. This way, the company would only have to refund travelers that can’t – or don’t want – to take the option of leaving earlier or later than planned but for the others, this might not be an issue.

This type of indicator doesn’t leverage predictive models, but only the risk owner’s expertise and experience. Still, it truly supports decision-making as the total impact of the risk of cancelling a flight would be documented, and the cost of the different responses would also be known.

Of course, the point of my short post today is not to say that one type of indicator is better than the other – or that airline companies should cancel flights 24 hours in advance! But I am trying to illustrate that both options can be complementary.

Do you currently use key risk indicators? If so, what type do you leverage most?

For more on forward-focused business strategies, see The 5 Most Important Tools of the Make for Me Future.

Thomas Frenehard

About Thomas Frenehard

Thomas Frénéhard is a director in the Governance, Risk, and Compliance Solution Management team at SAP. His particular responsibility is with SAP Risk Management. Thomas's other functional areas of focus are in internal control and compliance management and audit management. In this role and in constant interactions with SAP’s network of partners, clients, and internal stakeholders, Thomas is responsible for bringing together technology, skills, and products to deliver an always-compelling solution for enterprise risk management.