1) Companies currently face risks outside of their core competencies.
Part of the reason that risk management is such a hot topic is that most of the corporate world has not yet learned how to deal with these noncore risks. For example, a manufacturing company is not in the business of monitoring the political ramifications of events around the world. Its core competency is making widgets; political issues are for politicians to worry about.
Because these risks are not its core business, it should be no surprise that the manufacturer does not know how to deal with them. That is why many companies are just now starting to ramp up their risk management programs. They have to deal with these risks to survive, but there is no way to lay off these risks.
2) Companies would very much like to lay off risks outside of their core competencies.
Myron Scholes and the $370 trillion (yes, "trillion" with a "t") notional value of the derivatives market are a testament to the appetite of companies to pay in order to be rid of certain forms of risk. For example, most global companies that are not in the business of trading currencies, choose to hedge their foreign currency risk. They will pay a premium to do so. The $400 billion of insurance capacity (a trifle compared to the capital markets as evidenced by the value of derivatives) exists because of this simple fact. If there is a way to transfer noncore risks, then companies will pay to do so.
3) Many risks cannot be passed off at any price.
The reason that ERM exists and is the area of focus for so many different professions is because there still exist huge, catastrophic risks that simply can't be transferred. Reputational risk, loss of key talent, shifts in the marketplace, failure to execute on a new initiative--these are all risks that do not yet have any transfer mechanism.
This represents a huge opportunity. While Wall Street has thousands of bright minds scouring the existing markets for opportunities to make a few extra basis points, there is an entire universe of untapped risk-transfer opportunity. While it might be very difficult to beat the market by transferring risk through hedges, futures and swaps, there is no competition whatsoever in this new risk market. If someone can develop products that will allow companies to spread, transfer or eliminate the big enterprise risks outside of their core competencies, they would have a very large blue ocean of wealth to themselves.
Perhaps the question is not why the reactionary insurance market has not tapped into this, but rather why the flush, hyperinnovative capital market players have not? I have developed a capital market solution that would cover all natural disaster business risk and profit whether or not a loss occurs. And I am not that bright. Surely sharper minds than mine could do the same with the common ERM risks such as reputation and HR risk. Come to think of it, the HR product would be very easy to develop as well.
4) Because many risks can't be transferred, companies must manage the risks in house and develop a core competency around ERM.
Therefore, companies must find ways to mitigate these risks through ERM, project management, internal audit or some other internal function. Most would probably prefer to simply sign a contract, pay a small price and have these risks taken off the books so that they can focus on the business at hand. I imagine most directors would like reputational risk to be a nonissue like foreign exchange. If it were, they could focus with single-minded clarity on the opportunities that they are pursuing.
Through ERM, we can create an environment where top management can focus on opportunities because the risks are well managed. The advances that have recently emerged that employ Bayesian analysis, expert elicitation, the use of influence diagrams and engineering root cause analysis have brought risk management to a level of sophistication that allows companies to manage their own operational risks much like a portfolio manager. While these are not yet widely adopted, they will be over the next ten years, just as CAPM was adopted by the capital markets.
5) The tools are being developed within companies that will facilitate the shift to more universal risk transfer.
In fact, if the risk management tools reach a sufficient level of proficiency, they will make it very easy for capital markets to step in a create risk-transfer solutions. In the future, risk managers will likely all be employed by risk-transfer firms, just as few companies today employ bond traders, preferring to farm out that function.
The real trick for this jump to occur will be to make risk quantifiable so that it can be transferred efficiently. Just like the cost of solar power, the price has to drop below the consumers' price threshold to become viable on a widespread basis. With the types of quantification methods already proven at Stanford and being employed by the likes of Vahid Kodakamari, this goal is getting close. All that is needed is someone in the capital markets or insurance realm smart enough, and wealthy enough, to understand that all risk is essentially the same and that existing risk-transfer products can be adapted for new forms of risk.
If ever the statement "risk is opportunity " were true, it is now. Risk, though it comes in many forms, is simply a representation of the uncertainty of the future. We do not know what is going to happen, so we have to develop methods to predict outcomes and manage contingencies.
No matter what the nature of the specific uncertainty, risk in any form can be quantified, packaged and transferred. It is not as if high-impact events such as hurricanes or market shifts such as currency fluctuations are inherently transferable. The book of Genesis does not include an eighth day in which God created derivatives and declared that certain risks could not be transferred.
Sooner or later, new products will be created. And it might not take a genius. The guys sitting around the coffee shop in London in the 1670s were not necessarily masterminds. Perhaps all that is needed is an understanding of the nature of uncertainty and how to monetize it. Let the race begin!
BEAUMONT VANCE manages risk for Sun Microsystems Inc. This column was a complimentary excerpt from one of his latest "Risk Management Reports" newsletters, which he edits and publishes. For more information on how to subscribe to the full version of the newsletter, please visit www.riskreports.com/.
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December 5, 2007
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