Enterprise Risk Management

The value proposition

KPMG study finds that ERM programs can reduce costs, improve efficiencies

By Michael J. Moody, MBA, ARM

Risk management has always been important in corporate America; however, it frequently has been difficult to build a convincing business case for it. Events over the past few years have proven that the lack of a proactive risk management program can have a serious effect on the viability of many going concerns. As a result, it should come as no surprise that many organizations are again reviewing the business case for risk management.

Generally, it is not too difficult to justify—from a management standpoint—the advantages of a risk management program, especially one that provides a holistic approach to risk management such as enterprise risk management (ERM). Among the obvious advantages are improved controls, better communications and decision-making, and a common language for risks. However, many corporate executives and board members are now asking: Can this new more robust risk management approach be justified from a measurable value-added standpoint?

Value-added approach

According to a new white paper from KPMG, titled “Placing a Value on Enterprise Risk Management,” there is significant justification for an ERM program. In fact, the paper addresses several specific aspects to an ERM program that will add value to any organization. And it does so by referring to several examples. One of the key questions that the paper sets out to answer is: “Would our company really make different decisions if it did have an ERM program?” According to KPMG, a good ERM program enhances the company value through reduced costs, decreased variability in financial results, enhanced market reputation, and improved business decision-making. Further, KPMG believes that it is possible to actually quantify the value that ERM delivers.

A similar exercise is important to any organization, whether it is just considering starting its own ERM program or planning on improving an existing program. The paper provides critical advice that can assist in justifying an ERM program and also addresses ways to improve an existing program’s performance.

Specific elements

One of the first issues addressed in the paper is capital costs, where KPMG notes that, for the most part, it is difficult for investors to have a complete understanding of a company’s financial position, even after referring to the most recent financial statements. Thus many investors turn either to equity analysts or bond rating agencies to provide insight into this important area. Over the past few years, rating agencies have begun to include an assessment of the ERM program as part of their overall rating. And while rating agencies initially limited their ERM program analysis to banks and insurance companies, they are expanding with increasing frequency their assessments to other industry segments.

Today, the ERM assessments can have a positive or negative impact on the overall company rating. Should the assessment be negative, for example, the overall rating could be lowered, thus leading to higher costs to access capital. The KPMG white paper provides a specific example that illustrates the dramatic effect of this single aspect. KPMG notes that, “A change in a company’s bond rating from A to an A- may result in an increase in new issue interest rates from 0.2% to 0.4%.” As they point out, this change may appear quite small, but when it is utilized in a $100 million bond issue, “it can result in $200,000 to $400,000 in additional interest expense per year.” Obviously, this is a meaningful number for any organization.

When some organizations begin to consider implementing an ERM program, they consider it just part of another in their endless compliance-related activities. This is a major mistake according to KPMG. They believe that an ERM program “can actually reduce compliance costs by aligning and streamlining existing risk assessment, risk monitoring, risk assurance and reporting efforts,” thus reducing redundancies as well as making the available information more useful. Frequently, an internal assessment will result in improved integration between ERM, strategic planning, compliance and internal audit activities. This exercise can also help to improve management and board understanding of risk assessment processes, underlying risks, risk inter-relationships and planning assumptions. All of these items will be of interest to the board as it moves toward greater risk oversight.

Frequently, the most tangible costs of any risk management program are the insurance costs. KPMG notes that, “ERM programs can help reduce hedging and insurance costs by more clearly identifying risk exposures, existing hedging and insurance offsets, and potential redundancies and inefficiencies.” A key element to the savings potential is the understanding and documentation of the specific underlying risks. Uncovering insurance policies and hedging activities that may be poor matches with the underlying exposures can create better transparency. And this, in turn, can lead to greater management attention and savings in hedging and insurance costs.

For far too long, risk management has focused too much of its attention on risk avoidance. ERM on the other hand, also considers the “upside” or opportunity aspects of risk. This approach allows management a better chance to develop an appropriate risk/reward decision-making process. If done properly, “ERM programs can play a vital role in identifying opportunities by creating processes, reports, and discussion venues to create greater transparency within the company.” As such, the ERM programs can monitor specific opportunities that have been brought to light via the risk assessment process.

But make no mistake, the heart of any ERM program “is to create processes to reduce losses or reputation damage.” While this has been a core concept of risk management programs for years, the tracking of results of the efforts has been less than successful for many companies. Of course, one of the reasons is the inability to place a value on events that did not happen. One method of developing a usable model for this important information, according to KPMG, is to track company and industry peers’ financial losses from various risk events. The advantage of providing this type of information is:

• It supports the ERM program value proposition.

• There is greater transparency resulting from this effort.

• Tracking and avoiding losses can lead to better risk estimations for individual and aggregate risks.

All of the above points can assist an organization in designing its loss mitigation strategies.

Finally, one of the major advantages of an ERM program is to reduce earnings variability. One method suggested by KPMG is to measure variability before and after ERM risk mitigation activities. Obviously, such an activity requires skill in both data management and risk modeling. To properly understand the “various earnings drivers, risk measurement techniques can be used to develop individual and aggregate risk estimates,” to properly judge the earnings variability.

Conclusion

Many of the large management consulting firms have begun to develop staff members dedicated to the ERM effort. Most of these organizations can quickly see that most of the new financial regula­tions that have come out or will be coming out place a heavy burden on the board for greatly increased risk oversight. As a result, many consulting firms are issuing white papers that provide significant insight into the ERM issue. For the most part, the papers offer excellent ideas and a good place to start a review of how to implement an ERM program, or update an existing program. The KMPG white paper is an excellent example of the information that is available to assist corporations in their quest for a “best-in-breed” risk management program.

The author
Michael J. Moody, MBA, ARM, is the managing director of Strategic Risk Financing, Inc. (SuRF). SuRF is an independent consulting firm that has been established to advance the practice of enterprise risk management. The primary goal of SuRF is to actively promote the concept of enterprise risk management by providing current, objective information about the concept, the structures being used, and the players involved.