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5.2: Enterprise Risk Management within Firm Goals

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    24494
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    Learning Objectives

    • In this section you will learn how the ERM function integrates well into the firm’s main theoretical and actual goal: to maximize value. We show a hypothetical example of ERM adding value to a firm.
    • We also discuss the ambiguities regarding the firm goals.

    As you saw in"4: Evolving Risk Management - Fundamental Tools", risk management functions represent an integrated function within the organization. In Figure 4.3.1, we map every risk. While the enterprise risk management (ERM) function compiles the information, every function should identify risks and examine risk management tools. Finance departments may take the lead, but engineering, legal, product development, and asset management teams also have input. The individual concerned with the organization’s ERM strategy is often given the position chief risk officer (CRO). The CRO is usually part of the corporation’s executive team and is responsible for all risk elements—pure and opportunity risks.

    In this section, we illustrate in simple terms how the function integrates well into the firm’s goal to maximize value. In terms of publicly traded corporations, maximizing value translates to maximizing the company’s stock value. Even nonpublicly traded firms share the same goal. With nonpublicly traded firms, the market isn’t available to explicitly recognize the company’s true value. Therefore, people may interpret the term “firm’s value” differently with public versus nonpublic companies. Instead of the simple stock value, nonpublic firms may well create value using inputs such as revenues, costs, or sources of financing (debt of equity). While “cash-rich” companies have greater value, they may not optimally use their money to invest in growth and future income. External variables, such as the 2008–2009 credit crisis, may well affect firm value, as can the weather, investors’ attitudes, and the like. In 2008 and 2009, even strong companies felt the effects from the credit crisis. Textron and other well-run companies saw their values plummet.

    The inputs for a model that determines value allow us to examine how each input functions in the context of all the other variables.See references to Capital versus Risks studies such as Etti G. Baranoff and Thomas W. Sager, “The Impact of Mortgage-backed Securities on Capital Requirements of Life Insurers in the Financial Crisis of 2007–2008,” Geneva Papers on Risk and Insurance Issues and Practice, The International Association for the Study of Insurance Economics 1018–5895/08, http://www.palgrave-journals.com/gpp; Etti G. Baranoff, Tom W. Sager, and Savas Papadopoulos, “Capital and Risk Revisited: A Structural Equation Model Approach for Life Insurers,” Journal of Risk and Insurance, 74, no. 3 (2007): 653–81; Etti G. Baranoff and Thomas W. Sager, “The Interrelationship among Organizational and Distribution Forms and Capital and Asset Risk Structures in the Life Insurance Industry,” Journal of Risk and Insurance 70, no. 3 (2003): 375; Etti G. Baranoff and Thomas W. Sager, “The Relationship between Asset Risk, Product Risk, and Capital in the Life Insurance Industry,” Journal of Banking and Finance 26, no. 6 (2002): 1181–97. Once we get an appropriate model, we can determine firms’ values and use these values to reach rational decisions. Traditionally, the drive for the firm to maximize value referred to the drive to maximize stockholders’ wealth. In other words, the literature referred to the maximization of the value of the firm’s shares (its market value, or the price of the stock times the number of shares traded, for a publicly traded firm). This approach replaces the traditional concept of profits maximization, or expected profit maximization, enabling us to introduce risky elements and statistical models into the decision-making process. We just have to decipher the particular model by which we wish to calculate the firm’s value and to enumerate the many factors (including risk variables from the enterprise risk map) that may affect firm value. Actual market value should reflect all these elements and includes all the information available to the market. This is the efficient-markets hypothesis.

    Recently, many developed countries have seen a tendency to change the rules of corporate governance. Traditionally, many people believed that a firm should serve only its shareholders. However, most people now believe that firms must satisfy the needs of all the stakeholders—including employees and their families, the public at large, customers, creditors, the government, and others. A company is a “good citizen” if it contributes to improving its communities and the environment. In some countries, corporate laws have changed to include these goals. This newer definition of corporate goals and values translates into a modified valuation formula/model that shows the firm responding to stakeholders’ needs as well as shareholder profits. These newly considered values are the hidden “good will” values that are necessary in a company’s risk management. We assume that a firm’s market value reflects the combined impact of all parameters and the considerations of all other stakeholders (employees, customers, creditors, etc.) A firm’s brand equity entails the value created by a company with a good reputation and good products. You may also hear the term a company’s “franchise value,” which is an alternative term for the same thing. It reflects positive corporate responsibility image.

    Maximization of Firm’s Value for Sustainability

    Another significant change in a way that firms are valued is the special attention that many are giving to general environmental considerations. A case in point is the issue of fuel and energy. In the summer of 2008, the cost of gas rising to over $150 a barrel and consumers paying more than $4 at the pump for a gallon of gas, alternatives have emerged globally. At the time of writing this textbook, the cost of gas had dropped significantly to as low as $1.50 per gallon at the pump, but the memory of the high prices, along with the major financial crisis, is a major incentive to production of alternative energy sources such as wind and sun. Fuel cost contributed in large part to the trouble that the U.S. automakers faced in December because they had continued to produce large gas-guzzlers such as sport-utility vehicles (SUVs) with minimal production of alternative gas-efficient cars like the Toyota Prius and Yaris, the Ford Fusion hybrid, and the Chevrolet Avio. With the U.S. government bailout of the U.S. automobile industry in December 2008 came a string of demands to modernize and to innovate with electric cars. Further, the government made it clear that Detroit must produce competitive products already offered by the other large automakers such as Toyota and Honda (which offered both its Accord and its Civic in hybrid form).See references to Capital versus Risks studies such as Etti G. Baranoff and Thomas W. Sager, “The Impact of Mortgage-backed Securities on Capital Requirements of Life Insurers in the Financial Crisis of 2007–2008,” Geneva Papers on Risk and Insurance Issues and Practice, The International Association for the Study of Insurance Economics 1018–5895/08, http://www.palgrave-journals.com/gpp; Etti G. Baranoff, Tom W. Sager, and Savas Papadopoulos, “Capital and Risk Revisited: A Structural Equation Model Approach for Life Insurers,” Journal of Risk and Insurance, 74, no. 3 (2007): 653–81; Etti G. Baranoff and Thomas W. Sager, “The Interrelationship among Organizational and Distribution Forms and Capital and Asset Risk Structures in the Life Insurance Industry,” Journal of Risk and Insurance 70, no. 3 (2003): 375; Etti G. Baranoff and Thomas W. Sager, “The Relationship between Asset Risk, Product Risk, and Capital in the Life Insurance Industry,” Journal of Banking and Finance 26, no. 6 (2002): 1181–97. Chevrolet will offer a plug-in car called the Volt in the spring of 2010 with a range of more than 80 mpg on a single charge. Chrysler and Ford plan to follow with their own hybrids by 2012.

    World population growth and fast growth among emerging economies have led us to believer that our environment has suffered immense and irrevocable damage.See environmental issues at http://environment.about.com/b/2009/01/20/obama-launches-new-white-house-web-site-environment-near-the-top-of-his-agenda .htm, http://environment.about.com/b/2009/01/12/billions-of-people-face-food-shortages-due-to-global-warming.htm, or http://environment.about.com/b/2009/01/20/obamas-first-100-days-an-environmental-agenda-for-obamas-first-100-days.htm. Its resources have been depleted; its atmosphere, land, and water quickly polluted; and its water, forests, and energy sources destroyed. The 2005 United Nations Millennium Ecosystem report from 2005 provides a glimpse into our ecosystem’s fast destruction. From a risk management point of view, these risks can destroy our universe, so their management is essential to sustainability. Sustainability, in a broad sense, is the capacity to maintain a certain process or state. It is now most frequently used in connection with biological and human systems. In an ecological context, sustainability can be defined as the ability of an ecosystem to maintain ecological processes and functions.http://en.Wikipedia.org/wiki/Sustainability. Some risk management textbooks regard the risk management for sustainability as the first priority, since doing business is irrelevant if we are destroying our planet and undoing all the man-made achievements.

    To reflect these considerations in practical decision making, we have to further adjust the definition and measurement of business goals. To be sensible, the firm must add a long-term perspective to its goals to include sustainable value maximization.

    How Risk Managers Can Maximize Values

    In this section we demonstrate how the concept of a firm maximizing its value can guide risk managers’ decisions. For simplicity’s sake, we provide an example. Assume that we base firm valuation on its forecasted future annual cash flow. Assume further that the annual cash flow stays roughly at the same level over time. We know that the annual cash flows are subject to fluctuations due to uncertainties and technological innovations, changing demand, and so forth.Capital budgeting is a major topic in financial management. The present value of a stream of projected income is compared to the initial outlay in order to make the decision whether to undertake the project. We discuss Net Present Value (NPV) in "4: Evolving Risk Management - Fundamental Tools" for the decision to adopt safety belts. For more methods, the student is invited to examine financial management textbooks. In order to explain the inclusion of risk management in the process, we use the following income statement example:This example follows Doherty’s 1985 Corporate Risk Management.

    Table 5.1 Example of an Income Statement Before Risk Management
    Income $1,000
    Salaries $800
    Interest $100
    Total expenses ($900)
    Profit $100

    Plotting the Risk Map

    Several sample risks are plotted in Notable Notions’ holistic risk map.The exercise is abridged for demonstrative purposes. An actual holistic risk mapping model would include many more risk intersection points plotted along the frequency/severity X and Y axes. This model can be used to help establish a risk-tolerance boundary and determine priority for risks facing the organization. Graphically, risk across the enterprise comes from four basic risk categories:

    1. natural and man-made risks (grouped together under the hazard risks),
    2. financial risks,
    3. business risks, and
    4. operational risks.

    Natural and man-made risks include unforeseen events that arise outside of the normal operating environment. The risk map denotes that the probability of a natural and man-made frequency is very low, but the potential severity is very high—for example, a tornado, valued at approximately $160 million. This risk is similar to earthquake, mold exposure, and even terrorism, all of which also fall into the low-frequency/high-severity quadrant. For example, in the aftermath of Hurricane Katrina, the New Orleans floods, and September 11, 2001, most corporations have reprioritized possible losses related to huge man-made and natural catastrophes. For example, more than 1,200 World Bank employees were sent home and barred from corporate headquarters for several days following an anthrax scare in the mailroom.Associated Press Newswire, May 22, 2002. This possibility exposes firms to large potential losses associated with an unexpected interruption to normal business operations. See the box in the introduction to this chapter "How to Handle the Risk Management of a Low-Frequency but Scary Risk Exposure: The Anthrax Scare".

    Financial risks arise from changing market conditions involving

    • prices,
    • volatility,
    • liquidity,
    • credit risk,
    • foreign exchange risk, and
    • general market recession (as in the third and fourth quarter of 2008).

    The credit crisis that arose in the third and fourth quarters of 2008 affected most businesses as economies around the world slowed down and consumers retrench and lower their spending. Thus, risk factors that may provide opportunities as well as potential loss as interest rates, foreign exchange rates are embedded in the risk map. We can display the opportunities—along with possible losses (as we show in "5: The Evolution of Risk Management - Enterprise Risk Management" in Figure 5.1.1).

    In our example, we can say that because of its global customer base, Notable Notions has a tremendous amount of exposure to exchange rate risk, which may provide opportunities as well as risks. In such cases, there is no frequency of loss and the opportunity risk is not part of the risk map shown in Figure 4.3.1. If Notable Notions was a highly leveraged company (meaning that the firm has taken many loans to finance its operations), the company would be at risk of inability to operate and pay salaries if credit lines dried out. However, if it is a conservative company with cash reserves for its operations, Notable Notions’ risk map denotes the high number (frequency) of transactions in addition to the high dollar exposure (severity) associated with adverse foreign exchange rate movement. The credit risk for loans did not even make the map, since there is no frequency of loss in the data base for the company. Methods used to control the risks and lower the frequency and severity of financial risks are discussed in "5: The Evolution of Risk Management - Enterprise Risk Management".

    One example of business risks is reputation risk, which is plotted in the high-frequency/high-severity quadrant. Only recently have we identified reputation risk in map models. Not only do manufacturers such as Coca-Cola rely on their high brand-name identification, so do smaller companies (like Notable Notions) whose customers rely on stellar business practices. One hiccup in the distribution chain causing nondelivery or inconsistent quality in an order can damage a company’s reputation and lead to canceled contracts. The downside of reputation damage is potentially significant and has a long recovery period. Companies and their risk managers currently rate loss of good reputation as one of the greatest corporate threats to the success or failure of their organization.“Risk Whistle: Reputation Risk,” Swiss Re publication, www.swissre.com. A case in point is the impact on Martha Stewart’s reputation after she was linked to an insider trading scandal involving the biotech firm ImClone.Geeta Anand, Jerry Arkon, and Chris Adams, “ImClone’s Ex-CEO Arrested, Charged with Insider Trading,” Wall Street Journal, June 13, 2002, 1. The day after the story was reported in the Wall Street Journal, the stock price of Martha Stewart Living Omnimedia declined almost 20 percent, costing Stewart herself nearly $200 million.

    Operational risks are those that relate to the ongoing day-to-day business activities of the organization. Here we reflect IT system failure exposure (which we will discuss in detail later in this chapter). On the figure above, this risk appears in the lower-left quadrant, low severity/low frequency. Hard data shows low down time related to IT system failure. (It is likely that this risk was originally more severe and has been reduced by backup systems and disaster recovery plans.) In the case of a nontechnology firm such as Notable Notions, electronic risk exposure and intellectual property risk are also plotted in the low-frequency/low-severity quadrant.

    A pure risk (like workers’ compensation) falls in the lower-right quadrant for Notable Notions. The organization experiences a high-frequency but low-severity outcome for workers’ compensation claims. Good internal record-keeping helps to track the experience data for Notable Notions and allows for an appropriate mitigation strategy.

    The location of each of the remaining data points on Figure 4.3.1 reflects an additional risk exposure for Notable Notions.

    Once a company or CRO has reviewed all these risks together, Notable Notions can create a cohesive and consistent holistic risk management strategy. Risk managers can also review a variety of effects that may not be apparent when exposures are isolated. Small problems in one department may cause big ones in another, and small risks that have high frequency in each department can become exponentially more severe in the aggregate. We will explore property and liability risks more in "9: Fundamental Doctrines Affecting Insurance Contracts" and "10: Structure and Analysis of Insurance Contracts".

    Key Takeaways

    • Communication is key in the risk management processes and there are various mediums in use such as policy statement and manuals.
    • The identification process includes profiling and risk mapping.

    Discussion Questions

    1. Design a brief risk management policy statement for a small child-care company. Remember to include the most important objectives.
    2. For the same child-care company, create a risk identification list and plot the risks on a risk map.
    3. Identify the nature of each risk on the risk map in terms of hazard risk, financial risk, business risk, and operational risks.
    4. For the child-care company, do you see any speculative or opportunity risks? Explain.