"Managing Risk in a Flat World", Minneapolis Star Tribune, September 19, 2005

The topic of risk management has been prominent in the news lately. Concerns about terrorism and natural disasters like Hurricane Katrina are raising the profile of this once-esoteric discipline.

Risk management is, after all, the foundation of all advanced civilization, as described in Peter Bernstein's 1998 classic, "Against the Gods: the Remarkable Story of Risk."

Quantifying risk is the action of those individuals or societies who attempt to influence their own future. The alternative is fatalism or superstition.

Risk management is most commonly associated with financial markets and insurance, but the concepts are applied to every aspect of society. In business, the transparency enabled by the rapid rise of business intranets and extranets is spurring a quiet revolution in the field of operation risk management.

"Balanced scorecards," which measure performance in terms other than financial, are an attempt to reduce the risk of corporate decisions based purely on financial indicators.

Sociopolitical Risk

What about the risk of social and political instability? Risk management does not imply risk avoidance. New or troubled markets often have monumental upside, with little competition.

An executive of my acquaintance had great success in the 1990s as the owner of a telecommunications provider in war-torn countries such as Lebanon, Kuwait and Somalia. The oil industry is remarkably sophisticated in assessing sociopolitical risks and makes profitable billion-dollar investments in troubled areas such as the Middle East and the former Soviet Union.

Sociopolitical risk is usually taken into account by executives assessing international market expansion. For those interested in the topic, read the June 2005 Harvard Business Review special section, "Risk and Rewards in World Markets."

But social and political risk is sometimes slighted in the process of selecting offshore outsourcing vendors. Risk management is considered relative to the vendor's ability to deliver. Savvy executives have learned to build a large buffer of cost savings in offshore outsourcing contracts as a hedge against the unexpected (i.e., a risk premium).

What is the appropriate additional risk premium particularly for companies considering outsourcing customer and knowledge-based functions?

The cost savings of offshoring can disappear by selecting a vendor in a country that is not an appropriate fit. Certain core principles should be applied before seriously considering anchoring a key element of your business offshore.

Ask yourself this question: Is this a country we want as a key element of our supply chain? A company with a global brand and a knowledge-based strategy would be foolhardy to become partners with firms in certain countries, however talented or inexpensive the services offered.

In September, 2002, I wrote a column exploring how dysfunctional countries stress and break in the age of globalization (see www.startribune.com/388).

It was based on a study by author Ralph Peters, titled "Spotting the Losers: Seven Signs of Non-Competitive States," originally published in 1998 in Parameters Magazine, the U.S. Army War College quarterly.

Peters described the cultural attributes that guarantee failure in the global economy. Briefly, these are restrictions on the free flow of information, the subjugation of women, inability to accept responsibility for individual or collective failure, the extended family or clan as the basic unit of social organization, domination by a restrictive religion, a low valuation of education and low prestige assigned to work.

There is no single useful metric that can quantify a sociopolitical risk premium for outsourcing. But broadly speaking, countries fall into four risk categories, based on Peters' seven rules:

Highly stable: Democratic, advanced economies that pass all of Peters' rules, such as European Union members, Japan and Australia. These countries, like the United States, would rather trade than fight.

Highly unstable: Countries that fail many or all of Peters' rules. However much potential their people have, their lack of stability as societies make signing service agreements with companies based there perilous. Afghanistan, Liberia and Syria are examples.

High potential, high risk: These countries pass most or all of Peters' seven rules but have erratic legal environments, in civil liberties, contract law, intellectual property and the intersection of all three. China and Russia lead this list, graded gingerly on human rights because their present societies appear benign compared with their horrific totalitarian pasts.

China already is a key player in outsourced manufacturing and is potentially a key player in information technology as well, with massive numbers of well-educated engineers. But the more China competes in high-value, knowledge-based services, the more China's political stability becomes a critical factor.

Highly stable, threatened externally: These countries are democracies with stellar human capital that pass all of Peters' rules. But each has external adversaries that threaten their existence with the potential of cataclysmic violence. India, Israel and Taiwan lead this list.

Despite their existential challenges, these countries continue to attract major investments from global corporate customers. Nevertheless, their risk must be acknowledged and planned for.