Although risk management is a system for controlling the exposures an organization has experienced and might conceivably face, it is by no means fool-proof, mainly because no one can possibly foresee every calamity that could befall an organization.

Take a major headline of the past couple of weeks, with plumes from a volcano in Iceland halting air traffic between several of the world's largest hubs. As a result, thousands of travelers were stranded in major airports with no relief in sight.

While this may not be a major insurance loss, it is most certainly a risk management crisis. People were trapped in airports with nowhere to go. Businesses were crippled.

From what I'm hearing, airport contingency plans for dealing with stranded passengers kicked in well. Cots were provided for people to sleep on. Food and beverages were available, and there were even temporary shower facilities set up.

In fact, this is exactly what risk management is all about—being prepared for the unforeseeable.

This brings me to a report by the World Economic Forum released this month, “Rethinking Risk Management in Financial Services—Practices From Other Domains.” The report makes risk management recommendations to the global financial sector based on the experience of several other industries.

The report explains that leading up to the recent economic crisis, many financial institutions had similar exposures not widely seen as important. And so when liquidity contracted suddenly and violently after the dive in housing prices, prompting the collapse of derivatives linked to mortgages, many institutions suffered horrendous losses simultaneously.

“As these institutions had similar funding structures, risk-management practices and mitigation strategies, it was as if someone had yelled 'Fire!' in a packed theatre, and all ran to the same exit,” the report said.

What was lacking was risk diversification. The report uses the example of a Chilean salmon farm, which lost millions of fish to a virus, costing thousands of jobs. It was found that the salmon were raised in over-crowded conditions, causing the virus to spread rapidly. Antibiotics made the fish more vulnerable in the long run as the bug became drug resistant.

The solution seems simple—don't pack the fish in so closely—but the organization, obsessed with short-term profits, ignored the obvious risks.

Similarly, financial institutions should vary their modeling assumptions for risk management. Boards, executives and investors need to think for themselves rather than implementing me-too strategies and depending on outside verification.

But while the report makes many good points about sharing findings across industries, it also stresses that all of this is futile if upper management turns a blind eye.

Many top managers in the financial sector, it said, had never experienced a significant crisis. Many also believed they were “too big to fail,” and operated under the “black swan” belief that a system-wide crisis was extraordinarily unlikely.

The biggest lesson here is that arrogance and ignorance will cause the most seemingly sound risk management systems to fail. Why? Because arrogance is blind to risk.

For this reason alone, it's imperative that upper management make room for and support criticism from within their organizations without fear of retaliation—something that was lacking in the troubled financial sector, the report found.

Part of sound risk management is putting the proper incentives in place, keeping the entire organization focused on the bigger picture. Yet the financial crisis was fueled by perverse incentives, including big bonuses based on short-term gains.

True risk management requires a much longer-term outlook.

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