By TOM HETTINGER, managing director of EMB America, and
ALICE GANNON, senior consultant
Spanning each step of ERM--identification, assessment, and mitigation or capitalization of risk--innovative tactics allow businesses to make strategic decisions that ultimately place them in an improved performance position.
Moreover, effective ERM strategies enable a company either to increase its profit while maintaining the same overall risk profile, or to maintain an acceptable level of profit while reducing total risk level.
The first challenge in ERM is to identify all significant risks across the business. This includes not only current and pressing risks, but also risks that may be dormant or newly emerging. Because this task is an ongoing effort rather than a one-time action, the process of identifying emerging risks as early as possible mandates an innovative approach.
How can a company ensure that this process continues and remains effective? An intuitive best practice revolves around creating a culture of risk communication. In companies that adopt this solution, a risk identification and management mindset is embedded throughout the organization both vertically and horizontally. More specifically, there is an awareness among virtually all managers and many nonmanagerial employees of the importance to identify anything that could interfere with the achievement of their area's and/or the company's goals, spurred by an active desire to find ways to mitigate that possibility.
Additionally, this companywide mentality is accompanied by an internal system of communication throughout the organization that encourages employees to share information that will uncover emerging risk possibilities.
This is most easily achieved by companies that already have a good internal communication system, including employee newsletters, visible channels for employees to provide feedback and suggestions to managers, and other areas such as regular employee surveys, both small group and large group employee meetings wherein an exchange of information is encouraged.
In companies with this type of internal communication system already in place, it is just a matter of including information about risks and risk management as a priority topic for communication.
If a company does not already have a good internal communication system, they will need to develop that system, which will benefit their ERM efforts, as well as pay off in other areas of the business.
Typically, the employees who are in the best position to first identify emerging risks rarely interact with others who hold risk management roles. However, with a companywide culture of communication implemented and with the appropriate communication paths established, these employees can contribute to the identification of risks much earlier than before. Early detection of the new risk, even just weeks sooner than would be possible previously, has the potential to save millions of dollars.
When examining the personal property insurance industry during the past two decades, this fact becomes clear. Billions of dollars of losses were paid out for a number of risks that were never considered by the underwriters and actuaries when writing the policies, and most companies were slow to acknowledge new and emerging risks to amend the policies.
For example, in the late 1990s and early 2000s, frontline claims personnel were noting an increase in mold claims, and therefore executives should have been aware of the increased risk of mold. As a result of the lag time accrued before the executive management team identified mold as a priority, millions of dollars were lost. Similar losses occurred with costly claims resulting from problems around sinkholes and leakage from residential oil storage tanks, and the underlying problem remains the same: a lack of communication.
A workforce with an ingrained culture of risk identification and communication can assure that risk mitigation actions begin much sooner and potentially save the company from these sizable losses.
Moving on to the second and third steps of ERM--assessment and capitalization of risk--innovative approaches have arisen around state-of-the-science modeling. These sophisticated computer models allow companies not only to understand the varying magnitudes of myriad risks, but also to coordinate this information companywide. As a result, all employees can make informed decisions.
Additionally, these models ensure that employees in each area of the company input the necessary information into the model so that each area's risk knowledge is captured easily. With the information in one central location, each area has access to consistent views of risk both within its specialty and across the company.
For example, state-of-the-science teams are using this type of modeling to create worldwide models. These models reflect catastrophes for individual regions and contagions and common events across the entire world. To understand this concept clearly, consider the following example: US companies that allocate capital by state might reflect hurricanes crossing state lines and show potential for tornadoes, while European-based companies would model windstorm and flood potential crossing through multiple countries and potentially different operating companies. Similarly, economic scenarios can be modeled using consistent economic assumptions throughout all areas of the company for each scenario. With this capability, companies can unite the business to ensure consistency in these events and their contagions.
Also, daily interaction with the models, including running "what if" options, allows ERM teams to help executives understand how their day-to-day business decisions impact capital and what their risk-adjusted targets should be to ensure a viable entity into the future.
These innovative ERM tactics all revolve around one central theme: collaboration. Without this integral component, ERM initiatives do not typically succeed.
Consider a risk that is identified and managed without a process to provide insight into how this risk aggregates across the entire business. While the management of this risk might be viewed as a success by the specific area of the company that this risk directly affects, its narrow view of the risk may not include the real impact that risk will have on the company as a whole as it compounds or diversifies the company's total risk profile. This lack of "big picture" risk management prevents a company from making optimal risk decisions.
Conversely, in collaborative ERM environments, each division of the company monitors actions associated with the risk to which they are most closely connected. This includes prediction of the effects their risk decisions will have on the total risk profile of the company, as well as monitoring of the impact on total risk levels of actions taken by other areas of the business. In short, each division considers the contagion effect of some risks and correlation among others.
Companies with this advanced ERM strategy have achieved a high level of integration of their individual risk management efforts across the entire organization. Moreover, they have established effective processes for all employees to communicate their awareness of current risk and predictions of future risk.
At the same time, successful organizations enable these employees to contribute to the approach taken to mitigate, transfer or capitalize upon risk. This shared responsibility with open communication manifests a consistent and collaborative process that enables the business to take a more holistic and organizationwide approach to risk management. The end result is a company's optimization of their value by selecting the best possible risk-reward tradeoffs.
September 15, 2008
Copyright 2008© LRP Publications