Elicitation and Elucidation of Risk Preferences

Motivation: Recent developments have created an increased interest among companies in developing formalized enterprise risk management (ERM) policies. Implicit in such an ERM policy is some statement of acceptable and unacceptable tradeoffs, or risk preferences. Since risk preferences will be a central part of the ERM policy, they should be explicitly determined. This would be accomplished through a process of eliciting and elucidating the risk preferences that management may already have in mind for operating the company.

Method: Several methods in current use are described, including survey and discussion group techniques.

Results: This report describes hypothetical results from applying the methods described in both business and non-business contexts.

Conclusions: Making risk preferences explicit enhances the development of an ERM policy. The elicitation and elucidation of risk preferences is neither simple nor brief. The process requires first that the meaning of risk be agreed upon and not assumed since different executives and professionals often have different definitions of risk. Technical survey techniques can be applied to elicit risk preferences. A number of results in behavioral finance are pertinent to risk preference elicitation.

Keywords: ERM, risk measure, risk preference, conjoint analysis, QFDI, behavioral finance.