Businesses take risks every day to create value for their shareholders. Managing those risks has always been an important element of running any enterprise, although the link to value creation has not always been clear. But growing demands from shareholders for senior management to take enterprise risk management (ERM) more seriously has at last formalized the essential connection between a company's business operations and its overall risk management program.
Until now, these functions have operated as silos within many organizations. For non-financial companies, in particular, the latest wave of corporate scandals and breakdowns in corporate controls has been a catalyst for revolutionary changes.
Inevitably, the initial stages of ERM have been mostly about compliance and corporate governance. New rules and responsibilities have been imposed on senior management and boards, which have resulted in higher costs, resource constraints and many questions about whether these new regulations are really the answer. But we are now entering a new era, where leading companies wish to harness ERM as a strategic tool that will help them increase shareholder value.
What follows describes a unifying framework that can be used to articulate risks consistently across an organization and evaluate alternative capital structures--comprising equity, debt, insurance and hedging--to bear those risks. Ultimately, ERM is about communication. Senior management must have well-developed, current information and credible insights to communicate the basis for its actions in both good times and bad.
Evolution of ERM
This framework is, in effect, the next step in the evolution of attempts to quantify and manage risk. And much of that effort has taken place in the financial services sector, among banks and insurers. While we often think today of banks as the leading risk managers in financial services, in fact, the evolution of ERM techniques owes a great deal to the insurance industry.
In the 1950s, the actuarial profession developed a formal asset/liability management (ALM) method for assessing and managing the interest rate risk embedded in the long-term products of life insurers. This method, known as "immunization," has since become the foundation of several risk management techniques in life insurance, pensions, banking and derivatives. The volatile interest rate environment of the late 1980s led to the development of more sophisticated ALM analysis, including the simulation of a wider set of risks and their financial impact over a variety of scenarios and...