erm imp material.docx

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Enterprise risk management is difficult to define, but generally it's a relatively new (less than a decade

old) management discipline that calls for corporations to identify all the risks they face, to decide which

risks to manage actively, and then to make that plan of action available to all stakeholders (not simply

shareholders) as part of their annual reports. (To read more about risk, check out Determining Risk And

The Risk Pyramid and Measuring And Managing Investment Risk.)

In putting together ERM initiatives, companies are supposed to focus not only on the downside of risk

but the upside as well. The traditional approach was to focus on the downside - the losses from currency

or interest rate trades in financial markets, for instance, or financial losses that might be caused by a

disruption in a supply chain or cyber or terrorism attack that impairs a company's information

technology.

In thinking about the upside, companies are supposed to consider competitive opportunities andstrategic advantages that might arise out of deft management of risk. Some of these "better decisions"

involve items like where to locate a plant or office abroad based on a risk analysis that would look at the

political environment in a country.

Evolving Risk Management

Studying how corporations manage the incredibly diverse number of risks they face - everything from

movements in currencies, interest rates to public perceptions of their reputations is playing an

extremely important role in the investment process. Knowledge of individual corporate "risk profiles"might have led you to invest in companies with the confidence that they could meet corporate

objectives and investor expectations (not only in good times, but also in bad). Knowledge of these

profiles might have also helped you identify up-and-coming organizations for investment - or helped you

better understand which companies to let into your community through a new plant or office, believing

that they would do everything possible to avoid environmental damage and to treat employees well.

Until now, particularly in the U.S., the vast majority of corporations have made very little information

about their overall risk profiles available to stakeholders. Companies in many other industrialized

countries, like Canada, the U.K. and Australia, are much more forthcoming about their risk and ERM

activities.


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The situation's poised to change as rating companies start to factor in a company's ability to manage

ERM. Stakeholders will start to gain a plethora of new risk-related data and information available to

them. This story of risk management is likely to expand greatly over the next decade.

ERM: A Constantly Changing Management Discipline

Of course, companies have been managing risk for years. Historically, they've done this by buying

insurance. More recently, companies have managed risk through the capital markets with "derivative

instruments" that help them manage the ups and downs of moment-to-moment movements in

currencies, interest rates, commodity prices and equities. From a mathematical point of view, all of

these risks or "exposures" have been reasonably easy to measure, with resulting profits and losses going

straight to the bottom line.

Where ERM comes in is where companies manage the risks that defy easy measurements or a

framework for management. These include crucial risks such as reputation, day-to-day operational

procedure, supply chain, legal and human resources management, financial and other controls related

to the Sarbanes-Oxley Act of 2002 (SOX), and overall governance. All of these and other exposures fall

under the ERM umbrella.

Back to the Upside

The "upside" that we discussed earlier also includes focusing on preventive measures that help a

company avoid potential disasters down the road. For example, some of these actions may include

determining when and how the physical assets they own need to be maintained and replaced. This way,

the company can avoid unexpected and costly plant and equipment failure that might result in

shutdowns, explosions or other events that put a company's employees, communities and reputations

at risk.

Understanding that their most important and valuable asset is their reputation, some companies work

proactively to protect the company when dealing with man-made or natural disasters. In one of themost storied reputation risk management stories in recent history, Tylenol found itself in need of a

burnished reputation in the face of product tampering. It reacted by being honest with the media and

quickly and aggressively removing and replacing its products at retail outlets. From 2006 to 2008, the

recent push for companies is to prove they are "going green", hoping that aggressive environmental risk

management will position their products, plants, supply chain and other operations positively with


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current and future customers. (Read more about this in For Companies, Green Is The New Black and The

Green Marketing Machine.)

How to Find ERM-Friendly Companies

It is a difficult task for investors to discover which companies are working to manage risk from an

enterprise-wide perspective - and an even more difficult job discovering who is doing so effectively.

Many board members don't understand ERM, believing it to be simply another potentially costly, hard-

to-measure regulatory fiat from Washington. Many others believe that effective ERM can be achieved

simply by expanding their SOX-related reporting and controls efforts, which is not the case.

Because it's a new management discipline, what constitutes "best practices" in ERM has yet to be

defined; currently it's being defined industry by industry, but few if any companies promote themselves

as being "best of the best" in ERM or risk management.

So, how do you know who's working hard at effective ERM? A growing number of companies,

particularly outside the U.S., devote a significant portion of their annual reports discussing risk

management, regardless of whether they specifically call it ERM. Generally, investors interested in

discovering who's doing a comprehensive job at risk management - and reporting it publicly in their

annuals - need to look abroad. Just north of the border, Canadian-based companies discuss risk

extensively in their annuals and they are a good place to start looking into this area further.

One way to quickly see if the company you are researching does have ERM is to check for a Chief Risk

Officer (CRO). While CROs are most often found in the energy, banking and insurance industries, more

aggressive manufacturing companies are moving in that direction as well. Another clue is found in a tiny

nut of companies that have managers specifically in charge of coordinating their ERM efforts. These

managers will have the words "enterprise risk" in their titles.

Intensive additional sleuthing from investors may offer worthwhile dividends. Simply searching"enterprise risk management" online will give investors access to numerous recent conference agendas

on the topic. Investors should then take note of which companies have executives lecturing on ERM.

Also check out the websites of the few associations dedicated to promoting ERM, such as the Risk &

Insurance Management Society in New York or the Committee of Chief Risk Officers. The Conference

Board in New York also has a dedicated practice examining corporations and their ERM endeavors, and


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the National Association of Corporate Directors has done a somewhat dated but invaluable Blue Ribbon

report on how corporate board members think about risk - and how that needs to change.

Risk Management Doesn't Mean Risk Free

As a word of caution, just because a company has a CRO - or brags about what it's doing in ERM -

doesn't mean you should take it at its word; you'll need to look deeper and ask investor relations

executives detailed questions. For years, the banking industry has boasted of having the best risk

management and ERM programs of any industry. None of that, however, prevented the 2007 credit

crunch and mortgage meltdown. (Keep reading about this subject in The Fuel That Fed The Subprime

Meltdown.)

Conclusion

The investment landscape is constantly changing and it is important to get a handle on which companies

are doing a good job at managing enterprise risk. This is a relatively young field of study, but it is worth

considering because it will continue to play a significant role in the investment community for many

years to come.

http://www.investopedia.com/articles/fundamental-analysis/08/enterprise-risk-management.asp

The Evolution of Enterprise Risk Management

The philosophy of enterprise risk management addresses issues that we, as a profession, have always

dealt with. Its evolution prescribes a new organizing concept in creating value for an entity.

By Robert Wolf

About a decade ago, the now popular study performed by Mercer Management Consulting firm cited

the primary causes of significant stock price failures amongst the Fortune 1000 Companies in the

booming '90s as events more descriptive under strategic and operational failures than events

traditionally categorized as hazardous and financial. Ninety percent of the cases were categorized undercauses that represented strategic and operational failures as the primary reasons for the stock drops. In

almost every instance, the study cited multiple reasons for each of the individual stock collapses. In

addition, in virtually every instance, the reason for the stock decline was categorized as a market

reaction to a series of unanticipated and correlated events that generated non-fortuitous domino

effectsbringing down the value of the firm.
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Traditional risk management has viewed risk as a series of single elements, or silos. Each risk stood alone

and was not related to the others. Optimizing risk management individually in each of the business units

of a company meant optimizing risk management in the company overall.

Traditional hazard/casualty risk management strategies were essentially comprised of buying insurance

that was inexpensive enough so that retained risk could be managed for as little cost as possible

internally. In other words, the typical marching orders for a risk manager at a company were, in essence,

"Here is your budget. Buy the cheapest insurance possible. Keep what you save. Use it to manage what

risk you retain. And, by the way, don't let anything bad happen." Optimizing traditional risk

management, in essence, meant keeping within risk management's expense budget.

Figure 1

Commodity price and interest rate fluctuation risks were hedged with trading instruments that were

deemed, until recently, the holy grail of hedging strategies for financial risks.

Other risks facing a company, which stem from strategic and operational failures, that made up the

aforementioned 90 percent of the stock failures in the '90s, and reflect the risks that could not be

traditionally transferred or traded away, were delegated to those managing the operations of the firm.

The Mercer study, in addition to discussions and papers written in various industry forums, prompted

discussion of whether stock price risk within a firm could be managed within a typical risk management

strategy. Can the traditional risk management toolkit address unanticipated/correlated events that have

the potential to destroy shareholder value at individual companies?

By implication of the study, one can suggest that since virtually all such failures result from multiple

correlated causes, only an integrated approach to risk management could recognize and mitigate

against such events. Herein lies the impetus of the current wave of interest in enterprise risk

management (ERM).

It is worth noting that none of the failures in the Mercer study were caused by such hazard risks as

lawsuits or natural or man-made disasters. The use of insurance to hedge such risks has worked in the

past for many years and continues to work today as an effective risk management tool. Insurance has


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naturally been a venue that the actuarial profession has served well in the past, and is expected to

continue to do so today and in the future.

It is also worth noting that a handful of the individual stock failures from the Mercer study were due to

risks typically financial in nature (6 percent), such as foreign macroeconomic issues, high input

commodity prices and interest rate fluctuations. These types of risks, at least in the 1990s, were deemed

to be appropriately managed by tools that have been generally accepted as effective instruments (e.g.,

derivatives, futures, etc.).

Financial risk management continues today as it was thena growing venue and opportunity for our

profession as actuaries continue to manage risk through the use of financial hedging instruments. It is

also a ripe opportunity for our profession to address the increasing fallout in credibility of traditional

financial models and instruments in use today. At the same time, we also need to address the increasingneed for improved tools and strategies to gauge the correlation of financial events that have dominoed

into a series of correlated outcomes and recently crippled the financial and credit markets.

The Evolving View of Risk Management truly represents the motivational evolution within business

communities. This motivational evolution has transcended the traditional goals of reducing costs and

reducing/avoiding/transferring risk to the more contemporary vision of maximizing revenue at

reasonable risk to add value, the essence statement of an ERM framework. From the realization that

silo-based risk management has its flaws, the emergence of new and larger risks (e-commerce, man-

made and natural catastrophes, Enron-esque risk), the steady consolidation of insurance and financial

institutions and the increased pressures on management accountability and corporate governance, the

ERM evolution continues to affect us today with opportunities for our profession to make a difference.

More comprehensive than the Committee of Sponsoring Organizations of the Treadway Commission

(COSO) framework, the ERM definition developed by the Casualty Actuarial Society and adopted by the

Society of Actuaries"the discipline by which an organization in any industry assesses, controls, exploits,

finances and monitors risk from all sources for the purpose of increasing the organization's short- and

long-term value to its stakeholders"suggests a dual role of managing both the risk and the returns of acompany. In essence, true ERM could really be coined enterprise risk and return management. Several

insurance companies, such as Allstate, are already using this terminology in their ERM framework.

At the end of the day, ERM does not encompass any new concepts. The philosophy of ERM addresses

issues that we, as a profession, have always dealt with. Its evolution prescribes a new organizing


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concept in creating value for an entity. How ERM adds value is in its conceptual framework of optimizing

strategies based on the characteristics and tools involving the laws of probability and statistics with

regards to diversification and correlation.

Traditional risk management, arguably, has long been based on diversification benefits. Even today,

some financial theorists argue that a company employing an ERM strategy does not add value to the

firm as risk management strategies are more efficiently carried out by investors outside the firm in

diversifying their respective investment portfolios. In addition to the argument that other stakeholders

also matter, I follow the counter-argument that unique risk (unique to the operations of the firm) is best

handled within a firm's operations and that optimizing risk and return strategies and business plans have

always been (and always should be) the foundation of a firm's strategies to maximize enterprise value.

Implementation of enterprise risk management has its challenges, some unique within various industryvenues. ERM is truly in different stages by industry and even in our profession's respective specialties.

These will be addressed in upcoming issues in this series where we discuss the evolution of enterprise

risk management and the various stages in our profession's specialty sectors: namely life insurance,

general insurance (property/casualty), health insurance, other financial institutions and non-financial

corporations.

However, in my experience with companies delving into an ERM-based culture, there are three general

challenges that pervade all industries and sectors. I consider these challenges our profession's

opportunity to make a difference in the sectors we currently serve and the ones we will serve in the

future. They are as follows:

Out of Sight, Out of Mind

In general, individuals, let alone companies, are extremely negligent in dealing with things that have

either just happened or have not happened recently.

We tend to optimize our strategies on risks after things (we tried to avoid) have just occurred. As a

baseball coach for my son's 12-year-old travel team, many times I have caught myself positioning my

outfielders in positions precisely where the last ball was hitwith the brilliant foresight that on the first

pitch to the next batter the ball will be hit to that same precise location.


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Most of us thought of 9/11 a lot on 9/12, 9/13 and for the subsequent years thereafter. But how many

of us thought of it today? How many of us think about possible and unimaginable risk events for

tomorrow? On 9/10, how many of us contemplated the possibility of 9/11?

Extreme event and catastrophe models have evolved in recent decades to provide a sense of loss

magnitude when extreme events, such as pandemics and natural or man-made catastrophes, occur.

Instead of focusing on whether these events are one in 100, one in 50 or one in five years (we just don't

know), our focus as a profession is to devise strategies of how to recover, whenever they may occur.

How much can we afford to lose? How can we split the damage? How much time do we have to

recover? What hedging and risk management strategies do we need in place to recover? In other words,

the opportunity for our profession to make a difference is to focus on recovery, rather than catastrophe.

Models that Do Assume Deviation and then Reversion to Normality

As practitioners, we tend to place full reliance on models that perform well under normal conditions.

But in reality, are situations ever normal? Our opportunity as a profession is to look beyond the models

that assume conditions revert back to the mean, that abnormal events are abnormal, that markets are

continuously efficient, and that human behavior follows precise mathematical and well-defined

distributional formulas, even as dominoes fall. This aspect is evident in today's financial times.

Budgets and Incentive Compensation

The greatest challenge I have seen in developing an ERM culture within a firm is in typical budget

mentality and incentive compensation. Budgets drive corporate behavior. Incentive compensation

drives goals and targets.

The opportunity for our profession in the ERM discipline is to devise effective means to promote the

ERM culture in firms via incentives. James Lam, in his book Enterprise Risk Management: From

Incentives to Controls, states that a great portion of the ERM discipline is in managing the behavior and

results of its people.

Incentive compensation plans that are earnings- and growth-based, solely due to targets within a

manager's strategic business unit, focus the manager on just his or her business unit's results with less

consideration to other business units and the company as a whole. Depending on the specifics of the


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incentive compensation plan, the manager may be motivated to take on more risk than is rewarded by

the returns.

On the other hand, incentive compensation plans should not be entire company goal-based, because, in

general, companies benefit from innovation and ingenuity within the strategic business units. Such

incentives should be in place to encourage originality and creativity within the units.

Where is the balance between rewarding/punishing an integrated result and promoting an

entrepreneurial innovation? Maintaining a true holistic view of risk across silos requires taking a true

holistic view of management behavior incentives in achieving the goals of the firm. Once again, the

ongoing theme of managing returns with the risks and managing the risks with the returns is prevalent.

It is this very essence that defines the evolution from traditional risk management to enterprise risk

management.

As risk management has evolved, so too has the very nature of our profession. The actuarial profession

has evolved, and continues to evolve, from traditional risk management to enterprise risk management.

The actuarial profession has outgrown the traditional risk management concept of being risk "costers"

or "provisioners." The actuarial profession used to primarily address how many people will die, get sick,

get in accidents, get sued, have property damage, etc. The days of solely communicating, "We need to

charge this amount to cover the expected costs (costing)," and/or "We need to set aside so many dollars

so that we have enough in the bank later to pay claims/benefits (reserving)," are gone.

In the ERM evolution, we address the profession's tagline, Actuaries: Risk is Opportunity. We are

speaking about risk/return strategies. We are recommending how much capital to hold to support the

risks underwritten at insurance companies. We are advising on competitive prices (pricing, not costing).

We are hedging long-term inflation risk with the investing of stock portfolios. We are hedging life

insurance products with variable annuity products.

On a macro basis, we are at the table discussing new ways to retire. We are discussing the health care

crises. We are discussing the availability and affordability issues in property insurance. We are discussing

strategic and operational risks.


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In subsequent issues, we will begin exploring opportunities to make a difference, starting with, but not

limited to, the individual backyards that we serve today and have the opportunity to do so in the future

in specific specialties.

http://www.soa.org/Library/Newsletters/The-Actuary-Magazine/2008/June/act-2008-vol5-iss3-

wolf.aspx

Enterprise Risk Management (ERM) versus Traditional Risk Management

All organizations are faced with risks that challenge the business. Successful firms are employing best

practice and a cohesive team and infrastructure to address the strategic, financial, operational, and

hazard risks that they face.

Recent Findings

In a traditional risk management service structure, the effort is departmentalized and focused primarily

on hazard risks. Using this approach, an organization rarely makes relative comparisons among its risks

to determine how they interact with one another or to evaluate their cumulative effect on the

organization. Conversely, in an ERM environment, there is a senior executive or Chief Risk Officer (CRO)

who compares and evaluates all of the risks the organization faces in a more holistic way.

Key Differences and Solutions

Enterprise risk management is an extension of traditional risk management, and differs in the following

ways.

Strategic application. An ERM approach is integrated into an organizations business decisions. Because

the effort is enterprise-wide, it supersedes any departmental or functional autonomy to encourage

continuous review and support of the organizations most value-based objectives.

Risks considered. ERM involves managing all of the risks affecting an organizations ability to meet its

goals, regardless of the types of risks being considered. This carefully reviewed and benchmarked

approach allows organizations the ability to stay focused on key areas of prosperity and survival.
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Performance metrics. ERM emphasizes results-based performance measurement throughout the

organization. Results indicate whether a risk management technique helped to achieve a business goal,

such as return on investment or return on assets. All forms of risk management, including ERM, are

intended to help minimize the adverse effects of missed opportunities and losses. The specific benefits

of ERM include maximizing the possible opportunities for growth, minimizing the expected

organizational losses and therefore increasing the expected income and asset value, and reducing the

residual uncertainty in all areas of the enterprise.

While many organizations have qualified representatives who are capable of managing their individual

functional risks, it is the unique and highly profitable organization that manages risk across the entire

enterprise.

http://www.blackburngroup.com/newsroom/124

Five Key Benefits

The most impact and recognition of value is often perceived more at the executive and director levels,

than other layers of management. Five key benefits and values from ERM include:

Increased consistency and communication of risks within the organization

Enhanced reporting and analysis of corporate risks (risk data)

Improved focus, attention and perspective to risk data

More efficient and effective activities related to regulatory, compliance and audit matters

More cost-effective management and monitoring of risks

Increased Consistency and Communication ERM provides a standard terminology and conceptual

framework for all members and departments in the organization. This consistency and commonality

provides improved opportunities for communication and coordination among various layers and

departments.

In addition, communication regarding risk is often lacking within organizations due to concerns of

confidentiality, propriety and job security. As a result, data and information relative to strategic risks,

and risks to achievement of corporate objectives and plans, are not shared across department lines.
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Enhanced Reporting Implementing ERM supports better structure, reporting and analysis of risks. Risk

dashboards, consolidating risks across the entire enterprise, increase the focus of directors and

executives, enabling better decisions relative to risk thresholds, risk appetite and risk tolerance. The

reporting, therefore, has better categorization and classification of risk data, allowing various types of

reporting (department vs. entity-wide, financial vs. compliance, high vs. low risk, quantitative vs.

qualitative factors, etc.).

Ultimately, the greatest overall value from ERM and related reporting is the timeliness, conciseness, and

flexibility, which facilitate improved decision making capabilities within the executive and director levels,

and in other layers of management.

ERM helps unlock synergies and potential for increased analysis and assessment of risks by

aggregating and sharing all corporate risk data and factors, and evaluating them on a consolidated basis.

Improved Focus and Perspective of Risk Data Utilizing ERM methodologies and techniques provides a

means to further identify and assess key performance indicators regarding risks. This allows a method to

measure and better quantify risk factors and tolerances. The use of key metrics and measurements of

risk further improve the value of reporting and analysis.

ERM models also permit more effective and complete viewpoints of risk. Traditional risk practices focus

on risk from a perspective of mitigation, acceptance or avoidance. However, effective ERM processes

will give management a framework in which to evaluate risk as an opportunity to increase competitive

positions and exploit certain market, operational and related conditions.

More Efficient Coordination of Regulatory and Compliance Matters Bond rating agencies, financial

statement auditors, regulatory examiners and other audit activities (including internal audit) have begun

to inquire, test, and often leverage and utilize monitoring and reporting data from ERM programs. Since

ERM data involves identifying and monitoring controls and mitigations relevant to various risks across

the organization, this information can provide an effective means for leveraging and reducing the effortand cost of such audits and reviews.

Cost Effective Management of Risk Through all of the benefits noted above, ERM enables better cost

management and cost effectiveness related to audit activities; better management of market,


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competitive and economic conditions; and increased leverage and consolidation of disparate risk

management functions.

Organizations can use ERM data and reporting to more effectively coordinate with investment

custodians, better manage capital/investment decisions and make more timely decisions regarding

hedging instruments. By potentially reducing the overall cost of risk management processes, reducing

audit costs or minimizing resources needed for regulatory responses, and streamlining monitoring and

reporting functions, ERM has the capability to reduce the cost of the existing processes and functions for

these respective components within the organization.

http://www.insideindianabusiness.com/contributors.asp?id=2148
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