Finance 590Enterprise Risk Management

Steve D’ArcyDepartment of Finance

Lecture 1

March 15, 2005

What is ERM?

ERM is the application of the basic risk management principles to all risks facing an organization

Other names for ERM

Enterprise-wide risk management

Holistic risk management

Integrated risk management

Strategic risk management

Global risk management

ERM FeaturesCulp - 2002

1. Consolidates risk exposures and identifies core and non-core risks

2. Views risk through common lens

3. Coordinates risk management process organizationally

• Systems• Processes• People

4. Innovates

Protecting Value Study 2004

• Sponsored by FM Global– Mutual commercial property insurer– Headquartered in Johnston, RI

• Conducted by Harris Interactive• Surveyed over 600

– CFOs and treasurers– Risk managers– Investment professionals– US and Europe

Survey Results

• ERM should be a board level issue– 90% CFOs, Treasurers and Risk Managers– 93% Investment Professionals

• ERM is a board level issue– 65% US– 93% Europe

Top Revenue DriversType of Asset CFO, Treasurer, Risk

Manager Response

Manufacturing plant, equipment and process

21%

Delivery/logistics 19%

IT/Telecommunications system

19%

Personnel and customer support

19%

Raw materials/inventory 15%

Intellectual property 7%

Top Hazard to Company’s Top Revenue DriverHazard CFOs, Risk

ManagersInvestment

Professionals

Brick and Mortar-Related 34% 3%

Supply Chain 14% 8%

Production-Related 14% 6%

IT/Telecommunications 7% 4%

Pricing Fluctuations 7% 39%

Government/Regulatory 5% 19%

Management Malfeasance 3% 13%

Legal 1% 5%

Labor Issues 15% 3%

Basic Risk Management Principles

1. Identifying loss exposures

2. Measuring loss exposures

3. Evaluating the different methods for handling risk

• Risk assumption• Risk transfer• Risk reduction

4. Selecting a method

5. Monitoring results

Why Manage Risk?

Diversifiable risk argument• Shareholders are diversified investors• They will not pay a premium to reduce unsystematic risk

How risk management can add value• Decreasing taxes• Decreasing the cost of financial distress

– Customers– Employees– Suppliers

• Facilitating optimal investment• Increasing firm value

Where Did ERM Come From?

Traditional risk management

Formally developed as a field in the 1960s

Focused on “pure” risks

Loss/no loss situation

Often could be insured

Developed from insurance purchasing area

New Elements of Risk – 1970s

Foreign exchange risk

End of Bretton Woods agreement in 1972

Commodity price risk

Oil price fluctuations of the 1970s

Equity risk

Development of option markets - 1973

Interest rate risk

Federal Reserve Board policy shift - 1979

Failure to Manage Financial Risk • Foreign exchange risk

– Laker Airlines – 1970s• Borrowing in dollars• Revenue in pounds

• Interest rate risk– U. S. Savings and Loans – 1980s

• Borrowing short• Lending long

• Commodity price risk– Continental Airlines – 1990

• Fuel costs not hedged• Oil price doubled with Gulf War

The “New” Risk Management -1980s

Financial risk management

Dealt with financial risk

Foreign exchange risk

Interest rate risk

Equity risk

Commodity price risk

Use derivatives to hedge financial risk

Financial Risk Management Toolbox

• Forwards

• Futures

• Options

• Swaps

New Elements of Risk – 1990s

• Failure to manage derivatives appropriately

• Financial model failures

• Improper accounting for derivatives

Mismanagement of Financial Risk• Mismanagement of derivatives

– Gibson Greetings– Proctor and Gamble– Barings Bank– Orange County

• Model failure– Long Term Capital

• Accounting improprieties– Enron– Cedant– Arthur Andersen

The “New” Risk Management - 1990s and beyond

• Enterprise Risk Management– Initial focus on avoiding derivative disasters– Developing into optimizing firm value

• Chief Risk Officer

• Sarbanes-Oxley Act – 2002

• Increased focus on risk models

Components of ERMLam 1999

• Corporate governance

• Line management

• Portfolio management

• Risk transfer

• Risk analytics

• Data and technology resources

• Stakeholder management

ERM Risk CategoriesCommon risk allocation• Hazard risk• Financial risk• Operational risk• Strategic riskBank view – New Basel Accord• Credit risk

– Loan and counterparty risk

• Market risk (financial risk)• Operational risk

Hazard Risk

• “Pure” loss situations

• Property

• Liability

• Employee related

• Independence of separate risks

• Risks can generally be handled by– Insurance, including self insurance– Avoidance– Transfer

Financial Risk

• Components– Foreign exchange rate– Equity– Interest rate– Commodity price

• Correlations among different risks

• Use of hedges, not insurance or risk transfer

• Securitization

Operational RiskCauses of operational risk• Internal processes• People• SystemsExamples• Product recall• Customer satisfaction• Information technology• Labor dispute• Management fraud

Strategic Risk

Examples

• Competition

• Regulation

• Technological innovation

• Political impediments

Enterprise Risk Management Infrastructure

• Analytics– Valuation models– Simulation models

• Data sets– Risk information– Transactions– Internal data (customers, risk limits, products)– Market data

• Reliable communications• Operations• Impact of technology

Evolution of ERM

• Control function– How much can we lose?

• Risk adjusted returns

• Capital allocation– Compensation– Bonuses

• Optimization– Maximize shareholder value– Vision of the future

Impediments to Effective ERM

• Risk models and technology

• Organization

• Motivation

• Operating infrastructure

• Data problems– Regional fiefdoms– High failure rate of IT projects

Increased Use of Risk Models

• Technological advances

• Theoretical advances

• Allocation of economic capital– Used for divisional profitability– Impacts bonuses– Dueling models

Chief Risk Officer

• Reports to CFO, CEO or Board

• Responsible for managing all aspects of risk

• Understand technology

• Communication skills

Traditional Risk Management Silos

• Financial risk – Treasury

• Insurance risk – Risk Management

• Operational risk – Business units

How ERM Can Increase Firm Value• Process can focus on protecting

– Value– Cash flows– Earnings

• Cannot protect all three at once• Examples

– Reducing taxes is earnings based strategy– Insuring to prevent assets from declining is value based– Hedging to maintain internal funding sources is cash

flow based

Increasing Firm Value

V = Σ FCFt / (1+k)t

V = Firm value

FCF = Free cash flow

k = cost of capital

Decreasing the volatility of future cash flows can decrease the cost of capital

Risk Structure

• Risk map– Frequency– Severity

• Capital structure

• Capital efficiency– Equity – capital adequacy– Debt – financial leverage– Insurance – risk leverage

Corporate Structure

• CFO – capital management

• CRO – risk management– Define risk– Gather information– Use information

• No consistent risk framework in place yet

• Need for risk balance sheet/income statement approach

– Control risk– Increase firm value

Essential Skills of a Risk ManagerFalkenstein - 2001

• Understand benefits and limitations of models

• Comprehension of data gathering process– Identifying essential data– Gathering information into central location– Interpreting reports

• Ability to focus on key risks

• Communication skills

Knowledge Base for Risk Manager

• Technical tools used in risk analysis

• Data integration expertise

• Understanding of how risk measures relate to strategic and tactical business decisions

Examples of ERM - 1

Michelin – contingent capital• Issued by Swiss Re New Markets and Societe Generale• Option to draw on subordinated long-term bank credit

facility• Option to issue subordinated debt at fixed spread

– This option can only be exercised if GDP growth falls below a trigger (1.5% 2001-03, 2.0% 2004-05)

Examples of ERM - 2

United Grain Growers – risk integration

• Issued by Swiss Re

• Grain volume coverage

• Integrated with other property/liability coverages

• Three year policy

• Annual aggregate retention

• $35 million annual limit

• $80 million policy limit

Examples of ERM - 3

RLI Corporation – Cat-E-Puts

• Arranged by Aon, issued by Centre Re

• Three year term

• Provided an option to issue $50 million in convertible preferred shares

• Trigger was major California earthquake

• Subject to minimum capital requirements

Future of ERM• ERM will continue as risk consolidation and

aggregation

• Process increases value of risk management skills

• Management is concerned with risk control issues

• Chief Risk Officer will be a visible figure in an organization

• Many paths to CRO, diverse skills required

• ERM’s role in optimization has a long way to go

• Potential benefit is worth pursuing for pioneers