Why is scenario analysis used in risk management?

Scenario analysis is a critical tool in risk management because it allows organizations to evaluate and understand the potential impacts of various future conditions. This approach involves examining different plausible scenarios—often including both favorable and unfavorable circumstances—to assess how these conditions might affect a company's risks and overall performance.

By simulating various situations and their potential effects, organizations can identify vulnerabilities and prepare strategies to mitigate risks. This proactive approach helps in making informed decisions and developing contingency plans, thereby improving resilience against uncertain future events.

In contrast, forecasting future profits from investments, deciding on the allocation of marketing resources, and validating historical performance of portfolios, while important activities, do not directly address the evaluation of risks stemming from potential future states. These activities are often focused on performance metrics or resource distribution rather than on understanding and mitigating risks through varying future scenarios.