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W. Jean Kwon, Ph.D., CPCU
School of Risk Management, St. Johns University
101 Murray Street
New York, NY 10007, USA
Phone: +1 (212) 277-5196
E-mail:
[email protected] Risk Management and Insurance: Perspectives in a Global Economy
12. Enterprise Risk Management
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Study Points
The evolution of enterprise risk management
Risk management fundamentals
The ERM framework
The risk management process
3
ERM Evolution (Figure 12.1)
Corporate level
ERM
Interdepartmental level
Plus strategic risk
Plus financial risk
Plus other operational risk
Departmental level
Hazard risk only
No integration
Partial integration
Full integration
4
ERM Evolution (Figure 12.1) (textbook version)
5
Risk Management Fundamentals
Risk management for corporations
Attempts to manage those risks that entail the possibility of
economic harm
A reduction in the value of existing wealth
An increase in future expenditures
A reduction in future income
An increase in the discount rate
The firm should identify all opportunities and threats,
quantify and prioritize them, and find means to manage
them collectively and effectively to enhance firm value.
It should be indifferent whether a risk is financial, operational or
strategic.
6
ERM Goals
ERM deals with all risks critical to the maintenance and
enhancement of firm value.
The risk manager should be indifferent whether a risk is financial,
operational or strategic.
A firm can alter its risk portfolio in three ways:
Modify its operations
Adjust its capital structure
Employ targeted financial instruments
7
ERM Goals
The Committee of Sponsoring Organizations of the
Treadway Commission (COSO)
An effective ERM approach should be oriented toward several sub-
goals:
Ensure that the firms risk appetite is aligned with its overall strategy;
Enhance risk response decisions
Reduce operational surprises and losses
Identify and act on (new) business opportunities from successfully
managing risks
Allow management effectively to assess the firms capital needs and
improve capital allocation
8
Impact of RM on Cash Flow Volatility (Figure 12.2)
Post-risk management
Likelihood
Pre-risk management
Cash Flow
9
The ERM Frameworks
The COSO Framework
The Australian/New Zealand Standard
AS/NZS 4360
The U.K. Risk Management Standard
The IRMAIRMICALARM standard
10
The ERM Process
11
The ERM Process (Figure 12.3)
ERM Committee
(Senior Management, Board, Department Heads and Risk Manager)
Goal Setting Risk Reporting and Communication Goal Achievement
Plan
Environmental Risk Risk
Administrat
Analysis Analysis Response
ion
Internal Environment Risk Quantification Control Implementation
External Environment Risk Mapping Financing Monitoring
Review
12
Environmental Analysis Internal
Sources of information
Financial statements
Examination of production operations
Questionnaires
Brainstorming sessions with key personnel
Scenario planning
Risks
Operational
Financial
13
Environmental Analysis Internal
Operational risks
Earnings can be affected by a host of risks.
Assets can be damaged, destroyed and stolen, and some become
obsolete over time.
Employee-related risks such as injury or death, resignation
(including being fired), strike or being the object of kidnappings and
ransom.
Legal liability is a major concern for businesses in several countries.
Table 12.1
Political risks are especially relevant for MNCs.
14
Top 10 Class Action Settlements (Securities Litigation)
Source: Stanford Securities Class Action Database jointly maintained by Cornerstone Research (2006)
15
Environmental Analysis Internal
Financial risks
Currency or foreign exchange rate risk
Interest rate risk
Input price risk
Output price risk
Credit (counterparty) risk
16
Environmental Analysis External
Threats and opportunities external to the organization fall
into the strategic risk category.
Strategic risks stemming from macroeconomic and other primarily
external influences and trends
Strategic risks usually being the responsibility at the highest levels of
the organization
Case
What seems to be purely an operational risk issue can escalate into
a disastrous reputational problem
The Royal Dutch/Shell case in Insight 15.5
17
Risk Quantification
Quantitative risks
Net present value (NPV) and internal rate of return (IRR) analyses
The capital asset pricing model (CAPM)
Value at risk (VaR)
Qualitative risks
Scenario planning
Brainstorming
Decision tree analysis
Figure
Classification And Regression Trees (CART) 12.4
Hazard and Operability (HAZOP) method
Program and Evaluation Review Technique (PERT)
18
Decision Tree Analysis (Figure 12.4)
The euro amounts are not based on any specific calculation.
19
Risk Mapping
Upon completion of the analysis process, the firm should be
able to quantify all risks identified objectively or subjectively
and then ranks the risks in the order of priority
Two approaches
The IRM-AIRMIC-ALARM approach (Table 12.2)
Risk mapping (Figure 12.5)
20
The IRM-AIRMIC-ALARM approach (Table 12.2)
The ERM committee is expected to enter types of risks in each cell (window).
21
Risk Mapping (Figure 12.5)
22
Risk Mapping (new)
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23
Risk Response
Risk control techniques
Avoidance
Loss prevention
Loss reduction
Risk-related management standards
International Organization for Standardization
ISO 9000 series
ISO 14000 series
Agenda 21
Table 12.3
24
Risk Control and Financing (Figure 12.7)
25
Yearly Comparison of Development (Figure 12.6)
Communication
5
4
3
Policy
2 Risk Identification
Administration
1
Risk Response
Risk Analysis
Year 2005
Year 2006
26
Risk Response
Risk financing techniques Refer also to Chapter 22 (Nonlife
Insurance) for liability insurance products.
Internal loss financing (retention)
Chapter 13
External loss financing
Chapter 14
Contractual transfer
Non-insurance transfer (e.g., hold harmless agreement)
Indemnification agreement
Hedging
Insurance
Part IV of this book
27
Plan Administration
An international RM program follows the same process as
managing purely domestic risks.
Businesses can alter their risk profiles by:
Changing operations
Altering their capital structure, and
Using targeted financial instruments
The techniques for addressing operational risks generally
are universal in concept but differ substantially in their
application internationally.
28
Plan Administration
Using a multinational program as an example
29
Plan Administration Decentralized Program
Relies heavily on local operations/foreign subsidiaries to
make their own risk management decisions
Benefits
Local office accountability enhanced
Local management show a strong interest in managing risk
Local operations/subsidiaries establish strong ties with local
governments and communities.
Insurance contracts issued in compliance with local regulations
Concerns
The MNC exercises little control over local RM activities
Lack of coordination between the corporate and local offices, thus
thwarting ERM efforts.
30
Plan Administration Centralized Program
The corporate office exerts primary control over the risk
management activities of remote operations and subsidiaries.
Benefits
Uniform approaches to risk, allowing stronger coordination
internationally and consistency with the ERM approach
Target financial instruments, such as insurance, being more consistent
Concerns
Conflict between corporate and local offices over local autonomy
Cost-of-risk allocations among subsidiaries
The corporate office may fail to respond on a timely basis to changes in
local conditions
31
Controlled Master Program (CMP) (new)
LOCA
L
HOME
LOCA
(MAST
L
LOCA ER)
L LOCA
L
LOCA
LOCA LOCA
L
L L
Source: Kwon (2004)
32
Discussion Questions
33
Discussion Question 1
Find a definition of risk management from a reliable source
and compare it with the definition of ERM in this book.
34
Discussion Question 2
Why is it important to have an effective communication
channel involving (the most) senior management in ERM?
35
Discussion Question 3
What similarities and differences can you find from the three
risk management standards discussed in this book the
COSO framework, Australian/New Zealand standard, and
the U.K. risk management standards?
36
Discussion Question 4
Other than the risks discussed in this book, identify and
discuss one risk that firms can easily quantify and another
that cannot be objectively quantified.
37
Discussion Question 5
Identify a representative MNC in your home country:
Classify its risks into financial, operational, and strategic.
Which risks, in your view, could cause (i) a significant reduction in
the value of the existing wealth of the firm, (ii) an increase in future
expenditures, and (iii) a reduction in future income?
Attempt to create a risk map using the identified risks.
38
Discussion Question 6
If the MNC that you identified has a risk management
program, find out whether it is an ERM program? If not,
what should the MNC do to have a true ERM program?
39
Discussion Question 7
The degree to which international risk management
programs are centralized or decentralized increasingly will
be patterned after the basic organizational structure and
operating philosophy of the firm, rather than by external
constraints. What are the external constraints?
40
