Enterprise Risk Management: Theory and Practice

There has been an intense change in the role of risk management over the past few decades. Moreover, in the last ten years, the work of the risk management has not only been the purchase of insurance but also expanded beyond its limits and evaded financial exposure to cater to various risks.

There are two ways in which corporations can manage their risks: tackling one risk at a time in a cataloged and devolved basis or working on all views in a systematic and corresponding manner (enterprise risk management, ERM).

Here, we suggest that the latter method is more advantageous than the former. In this document, we shall discuss the advantage of ERM to companies and their shareholders, methods, and encounters involved in the implementation of ERM, how corporations should access their desired risks profiles and adequate evaluations of these processes.

How Shareholders Worth is Created by Enterprise Risk Management

The value created by ERM is dependent on its effects at various levels. At the company level, it enables the management to calculate and manage the risk-return trade-off that faces the entire firm thereby helping the business have access to the capitals necessary for the implementation of the business plan.

On all levels, ERM is a practical necessity. Therefore, a good ERM system ensures that everyone throughout the firm assesses carefully the risk-return trade-offs, and has a responsibility towards material risk. Throughout this chapter, the company level and business level may be referred to as the macro and micro levels, respectively.

The Macro Benefits of Risk Management

First-year business students are taught that since shareholders can diversify their portfolios, the value of a firm is not proportional to its cumulative risks.

A company’s value of capital, which determines its P/E ratio, depends on the universal component of that risk – implying it is a waste of resources to be managing all risks. However, investors’ information is often incomplete and financial troubles may disrupt a company’s operations.

Therefore, it is not surprising for insurance companies not to provide insurance indentures that give full coverage for wage shortfall. The covered company should know more than the insurers their future earnings projections and how to maximize the payouts of the insurances policies– which is referred to as adverse selection.

A firm that has signed into a products contract with its wages as the underlying is as advantageous as byproduct dealers. Moreover, companies should seek guidance on the principle of relative advantage in risk-bearing. If a company lacks special ability to forecast market variables, then it also lacks a relative advantage associated with these variables.

In comparison, another corporation could have a relative advantage in bearing statistics intensive, firm-specific risks. The benefit of thinking in terms of comparative advantage is to emphasize that corporations are in business to take strategies and business risks. There are no economical ways of transferring risks that are unique to a company’s business operation. By decreasing non-core disclosures, ERM enables companies to take more strategic business risks and profit from these opportunities.

The Micro benefits of ERM

The work of a CRO and the senior management is to provide the important statistics and reasons for each unit in a company so that trade-offs serve their interests of the shareholders. The main ways of decentralizing the risk-return trade-off in a firm are by:

  • Evaluating all major risk from managers planning new projects, and their returns so as to achieve an ideal amount of risk at the business level; and
  • In order to ensure that the managers’ job of assessing the risk-return trade-off is efficient, each account of contribution in each unit, to the total risk of the firm must be computed.

In respect to the two points above, it is crystal clear that a firm which implements ERM can transmute its culture. In nationwide, factor-based capital allocation has been developed for the management and its risks factors updated annually as part of the strategic and operational planning process. Risk-limiting structure that is dependable with risk-taking is important in delegating decision making authority.

Determining the right amount of risk

It is important to note that the cost associated with the shortfalls of cash would not exist if the company had a larger safeguard stock equity capital; however, that that would be costly. Therefore, a company reduces the cost of expensive equity capital by reducing the risks hence making risk management a substitute for equity capital. This duty is usually taken by the top management of the firm.

The management can achieve an ERM program by limiting the barriers and losses of value so as to maximize the value of the firm. This is not the main work of the management; most of their job has to do with the optimization of the company’s risk portfolio and making critical decisions.

The management helps the ERM program in the following ways:

  1. Choosing the most probable financial distress which maximizes the firm’s value;
  2. Estimating the amount of capital needed to support the risks of the firm’s operations;
  3. Determining the optimal combination of capital and risk that to yield the firm’s target ratings;
  4. Decentralizing the risk of capital trade-off by the adequate allocation of capital and evaluating the performance of the management to boost its motivation.

Implementing ERM

For the implementation of ERM to be successful, everyone in the firm should understand that they need to create value. The management should understand that it is not only an academic exercise but also a critical tool in achieving the company’s strategy. We shall consider next some factors that challenge the ERM.

Inventory of risks

In ERM operationalization, the initial step is to identify the risks that the company is exposed to; this includes operational risks, except market and credit risks. Apart from market, operational, and credit risks, banks have gone beyond these limits to monitor strategic, liquidity, and reputational risks.

The management should find a dependable way to amount up to the company’s exposure to risks only after identifying the major ones. Bottom-up and top-down approaches of identifying risk are often used.

Economic value versus Accounting performance

Apart from the importance of credit ratings, the recognition of rating limitations is key, and the management should also rely on economic-based analyses. This is to act as a guide in the capital structure policy and risk management processes.

Based on a firm’s benchmarks, there are certain top-down approaches that provide estimates of total risks which are implementable; although not useful in risk management. Thus, the implementation of ERM must estimate the expected distribution of these changes on the company’s balance sheet from the bottom up. Some insurance companies have come up with stochastic models as an essential part of their ERM program, so as to generate multi-year cash flow distributions for its main businesses.

The Accounting Problem

A company focuses its financial value by focusing on its cash flows. However, helping a company achieves its targets can result in increased volatile wages. Even though companies should pursue the most profitable financial outcomes, they need to also “smooth” their earnings.

Aggregating risks

A firm using the three-part typology of market, credit, and operational risk processes needs to evaluate each risk individually. These three risks have different supplies. Market risk has an asymmetric distribution. However, both credit and operational have unequal deliveries. For credit risk, the creditors’ losses can be large whereas, for operational risk, there is a great sum of small losses. Statisticians use the term “fat tail” supply when the probability of extreme losses is greater than the normal supply.

When accumulating risks, one must approximate their relationships. There is a variation across risks groupings and the firm-wide VaR is less than their sum. The magnitude depends on the relationship between the risks. Hence, companies prefer using the average of the relationships used by others in their industry. Correlations increase in a highly stressed environment and, therefore, estimating correlation across the risks is recognizing that they depend on the actions of the company.

Measuring risks

Some firms focus on tail risks. Therefore, they measure the risk of changes in the present value of cash flows. Some also supplement their VaR approximations with street experiments. The main problem of VaR is that it measures losses expected to be surpassed with a stated probability. Some argue that companies should focus on expected loss if VaR is exceeded. In all cases, companies should look beyond the VaR processes and focus on the ERM to increase the value of the firm.

A company having a high target rating causes the valuation of VaR to become an art since estimated VaR matches to a very low probability level. As an example, the probability of default of A-rated companies is 0.08%, and only a few companies have had such losses making it difficult to estimate VaR probabilistically. However, due to the data abundance on downgrades, distribution changes in firm values can be more precisely estimated.

Regulatory versus economic capital

The capital required by a company to achieve an optimal rating has little relationship with the capital regulators require. Some insurance companies allocate the remaining stranded capital to their business and products. Due to the ERM system, firms focus mostly on generally accepted accounting principles (GAAP) and economic capital, but the conformation and liquidity of the capital also matter.

Using economic capital to make decisions

A company’s potential financial distress increases when it undertakes a new risky endeavor. However, this is avoidable by raising adequate surplus capital. Business units must have enough knowledge in deciding how to evaluate contributions, and many companies dodge correlations in setting capital causing the project to obtain no profit from diversification. The managers of a company’s business unit should determine the capital allocated to new a project to keep the firms risk-constant.

The governance of ERM

One result of operational ERM should be a better estimate of anticipated value. ERM does not eliminate risks; however, it limits the probability of extreme negative outcomes. To evaluate the work of a CRO, the board and the CEO must try to decide how the firm’s risk is managed and understood. This helps the company to grasp the resources it requires to undertake valuable new projects.

Practice Questions

1) In decentralizing the risk-return trade-off in a company, managers are required to perform which of the following activities?

  1. Conducting a firm’s audit
  2. Delegating duties
  3. Hiring a third party to conduct a firm’s audit
  4. Highlighting new important projects

The correct answer is D.

The first three activities are important activities but are not required during the decentralizing of the risk-return trade-off. Managers are supposed to highlight important projects that can help mitigate the risks.

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