Chapter 5

Risk Quantification

Any intelligent fool can invent further complications, but it takes a genius to retain, or recapture, simplicity.

E.F. Schumacher

The risk quantification ERM process step is the lynchpin of the ERM process cycle. It enhances the key risk ranking and prioritization performed in the prior ERM process step—risk identification—and it also provides the information necessary to perform the next ERM process step—risk decision making. The key linkage performed in this step is the connection of risk and value by quantifying risk in terms of its value impact. This is the bridge between risk and return.

In this chapter, we will address risk quantification as performed using the value-based ERM approach. Risk quantification is performed with the value-based ERM model. By model, we mean a financial model in the form of a spreadsheet-based tool. The model receives input of data and assumptions, performs calculations, and produces output of results.

Before we discuss the risk quantification activities, we will emphasize the most critical overriding characteristic of the value-based ERM model: practicality.

Practical Modeling

The single most important characteristic of the value-based ERM model is that it is practical. All aspects of the model—inputs, calculations, and outputs—are kept simple, with the sole purpose, constantly in mind, of supporting decision making. As was discussed in some detail in Chapter 3, there are four aspects to this practicality:

1. Reliability. ...

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