Enterprise Risk Management - Essay Example

Table of Contents Table of Contents 1 Introduction 2 2 Conceptual Definitions 3 2 Enterprise Risk Management 3 2.2 Risk Management 4 3 ERM vs RM 5 3.1 RM Drawbacks 5 3.2 ERM Drawbacks 5 4 Implementation Issues 6 5 Conclusion 8 6 References 9 1 Introduction Risk management and enterprise risk management stand out as popular strategies for the management of insurance risks. As several risk management scholars have pointed out, very few issues have occupied corporate managers over the years as have the management of financial risk and the transfer of insurable financial losses, such as property and liability losses (Doherty and Dionne, 1993; Doherty, 2000). In response to this concern, several risk management strategies have emerged, with the two most popular and effective being risk management and enterprise risk management. Risk management, although it has proven its effectiveness over the years and, most especially, the relative ease of its implementation, is regarded as inferior to enterprise risk management. The reason lies in that it lacks the integrated approach to the management of risk which characterises enterprise risk management. It is precisely for this reason that regulators in Canada, Germany, the United Kingdom, the United States, and other developed countries have issued rules and guidelines that advocate an enterprise-wide approach to risk management, further pushing many companies to adopt ERM (Kleffner, Lee and McGannon, 2003). Quite simply stated, the drive towards the adoption of ERM, as opposed to RM is due to the fact that the integrated approach adopted by the former, and which is absent within the context of the latter, is regarded as a more effective and efficient approach to risk management. With that being the case, as this research will argue, the real question relates to the reasons why more corporations do not adopt ERM, as opposed to RM. 2 Conceptual Definitions In order to properly determine the reasons why ERM is considered superior to RM, it is important to define each of the two terms. These definitions will highlight the advantages and disadvantages of either approach and allow for a greater understanding of differences between them. 2.1 Enterprise Risk Management Enterprise risk management has become a significant topic for large global financial organizations over the past decade. It provides an active, vital and comprehensive modelling approach for integrating all financial decisions and risks. This includes investment decisions, borrowing policies, liability, and setting of goals (Kleffner, Lee and McGannon, 2003). The comprehensive management of risks and the adoption of an integrated approach to risk management has several benefits. An enterprise with fully diversified losses requires much less capital than an enterprise with concentrated worst-case losses. In turn, the anticipated profitability of the company is affected by the degree of diversification since a reduction in capital will increase expected profits. The goal of ERM is to maximize the firm's overall profit, while maintaining its enterprise risks at acceptable levels (Mudge, 2000). Insurance companies, for example, should analyze their major risks so that adequate capital exists at the firm level to pay insurance policyholders in the event of legitimate insured losses. The desired level of capital depends upon the severity of claims. And since these claims are a direct function of random events, the insurance company must calculate a distribution of losses for its entire operations in order to set the proper level of firm-wide capital (Doherty, 2000). Due to this, Meulbroek (2002) insists that regulatory bodies should check these systems in order to validate that the risk management strategies are reasonably well developed and consistent with current approaches and practice. The firm-wide models are also known as Dynamic Financial Analysis. An ERM system consists of three primary elements. These are 1) a stochastic model for projecting a set of scenarios of the future --the scenario generator; 2) a decision or policy rule simulator; and 3) a stochastic optimization module (such as stochastic program) for identifying the best compromise among the competing objectives - the search procedure (Doherty, 2000). The output of the ERM system is a set of recommended asset strategies and the probabilistic impacts of these strategies on the major aspects of the entity under study. 2.2 Risk Management Risk management, which is primarily concerned with insurance, proceeds from the basic position that it is impossible for an organisation to eliminate all sources of financial risk and that, irrespective of the financial management strategies adopted, residual risk is always present. Accordingly, while it does not seek the elimination of risk, risk management determines the minimisation of risk to acceptable, and sustainable, levels. It does so through the selection of cost-effective approaches and strategies to the aversion of the more pressing of the financial risks which a company may incur (Mudge, 2000; Kleffner, Lee and McGannon, 2003). The primary rationale behind risk management is that overall risks, or the totality of risks which an organisation confronts are almost impossible to accurately assess and, hence, effectively manage. In direct comparison, however, the risks which individual units within an organisation may confront are much easier to assess and, therefore, manage. As such, risk management unfolds within the context of individual business units and are undertaken by managers. 3 ERM vs RM While not discounting the fact that traditional risk management has significantly contributed to the minimization, or control, of the volume of financial risks incurred by a company, the fact is that it has several drawbacks. This does not mean to imply that enterprise resource management is without disadvantages but that a comparison between the two will evidence the superiority of the latter. 3.1 RM Drawbacks There are several drawbacks to traditional RM approaches, proceeding with the tendency to focus, almost to the exclusion of all else, on insurance. Following from that, RM maintains the imperatives of objectively measuring risk which, in and by itself, is not always practical or possible and, quite often, culminates in interference with the firm's profit generating and value-maximisation activities. As serious as these drawbacks might be, they are minimal in comparison to this approach's failure to embrace an integrated, holistic, view of risk management. 3.2 ERM Drawbacks In direct comparison to the above-stated, ERM maintains the possibility of risk-aversion and adopts a holistic approach to its attainment. Rather than operate on individual business unit levels, it is integrated into the organisation itself, to the extent that it becomes an integral part of the organisation-wide management paradigm. Following from the aforementioned, ERM determines the mitigation of risk through the proactive management of risk through its continued and constant monitoring, assessment and evaluation. While its holistic approach and the very fact of its integration into an organisation's management paradigm and business processes comprise ERM's chief sources of strength, they also account for its weaknesses. Indeed, as several researchers have pointed out, the implementation of ERM is highly problematic consequent to the imperatives of integrating it into existing management paradigms and business processes, with the implication of the aforementioned extended to training and educating employees and managers in its utilisation. Added to that, its operationalisation is time-consuming and, in some instances, pressure on company resources. This is because it involves the constant monitoring of risk and the critical evaluation of options prior to the selection and implementation of any, as determined by risk assessment outcomes (Stultz, 1996; Schrand and Unal, 1998; Froot, 1999; Cummins, Phillips, and Smith, 2001; Lam, 2001; Lee, 2003). In other words, ERM drawbacks are directly related to implementation issues and the continued cost (as in time and resources) of its maintenance/operationalisation. 4 Implementation Issues Considering that theory tends towards the view that ERM is superior to traditional RM approaches, the question of why larger numbers of firm do not implement it, naturally comes to mind. This question can best be answered through both a recollection and reaffirmation of the drawbacks noted in the preceding section, on the one hand, and the problematic nature of implementation, on the other. In order to explain this, it is necessary to review the theoretical implications of ERM and the resultant implementation requirements. ERM embraces a number of risk reduction theories and tools, with the more significant/important ones being risk allocation, financial distress costs and financial shock crisis (Froot, Scharfstein and Stein, 1993; Schrand and Unal, 1998; Froot, 1999). Each of the aforementioned are quite complex, require training and education and are constrained by the problematic of implementation. Added to that, researchers have not attained consensus regarding which of these extends the more effective and efficient enterprise-wide risk management tools. Some argue that hedging can reduce the volatility of the income stream and thus help ensure the firm has adequate internal funds available to profitable investments. Myers (1977) suggests that firms can prevent underinvestment problem by building up financial slack, while Froot et a1 (1993) point out that hedging can also mitigate liquidity constraint and underinvestment problem by reducing the firm's dependence on external finds. Froot et al. (1993) propose that firms with low liquidity positions and high growth opportunities are more likely to hedge. Geczy, Minton and Schrand (1997) use quick ratio as proxy for liquidity and three proxies for growth opportunities in a logit regression to determine the factors affecting derivative usage. The implication here is that companies cannot simply determine the implementation of ERM but have to engage in the design of the ERM model that they will ultimately implement and, importantly. This in itself is time-consuming and can turn into a trial and error process. Further evidencing the problematic nature of implementation is Meulbroek's discussion of ERM implementation. Meulbroek (2002) outlines three fundamental ways to implement ERM: hedging with financial derivatives, adjusting capital structure, and investment policy. The model, which is supposed to simplify, or facilitate the implementation of ERM, actually stands out as evidence of the fundamentally complicated nature of this task. As based on the above stated, therefore, it is evident that despite the superiority of ERM, the complex nature of its implementation constrains its adoption, despite its superiority to RM. 5 Conclusion As evidenced in the argument presented in the foregoing and, as further established through reference to risk management theory and empirical evidence, ERM is ideally suited for the management of insurance risk i. It most certainly does not eliminate the potentialities of risk or of the loss that can be incurred as a result but it effectively and efficiently manages the said risk and, in so doing, significantly minimises it. That said, however, and despite its superiority to RM, it is not as widely implemented as one would have expected because of the difficulties associated with ERM implementation. 6 References Cummins, J., D. Phillips, and S. Smith, 2001, "Derivatives and Corporate Risk Management: Participation and Volume Decisions in the Insurance Industry", Journal of Risk & Insurance, 68: 5 1-92. Doherty, Neil A., and G. Dionne, 1993, "Insurance with Undiversifiable Risk: Contract Structure and Organizational Form of Insurance Firms", Journal of Risk and Uncertainty, 6: 187-203. Doherty, Neil A., 2000, Integrated Risk Management: Techniques and Strategies for Managing Corporate Risk, New York City, New York: McGraw-Hill Professional, 2nd Ed. Froot, K., D. Scharfstein, and J. Stein, 1993, "Risk Management: Coordinating Corporate Investment and Financing Policies", Journal of Finance, 48: 1629- 1658. Froot, K. and J. Stein, 1998, "Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach," Journal of Financial Economics, 47: 55-82. Froot, Kenneth A., 1999, "The Evolving Market for Catastrophic Event Risk", NBER Working Paper Series No. W7287. Geczy, C., B. Minton, and C. Schrand, 1997, "Why Firms Use Currency Derivatives", Journal of Finance, 52: 1323-1354. Kleffner, A. E., R. B. Lee and B. McGannon, 2003, "The Effect of Corporate Governance on the Use of Enterprise Risk Management: Evidence from Canada", Risk Management and Insurance Review, 6: 53-74. Lam, J., 2001, The CRO is here to Stay, Risk Management, 16-20. Lee, H., 2003, Investments, Stock Returns, and Interest Rate Swaps, New York University, Working Paper. Meulbroek, L., 2002, "Integrated Risk Management for the Firm: a Senior Manager's Guide", Journal of Applied Corporate Finance, 14: 56-70. Mudge, Dan. 2000. The Urge to Merge, Risk Magazine, February 2003: 64. Myers, S., 1984, The Capital Structure Puzzle, Journal of Finance, 39: 575-592. Schrand, C., and H. Unal, H., 1998, "Hedging and Coordinated Risk Management: Evidence from Thrift Conversions", Journal of Finance, 53 : 979- 10 13 Smith, C. and R. Stulz, 1985, "The Determinants of Firms' Hedging Policies", Journal of Financial and Quantitative Analysis, 9 : 8-24. Stulz, R., 1996, "Rethinking Risk Management", Journal of Applied Corporate Finance, Fall 1996, 8-24. Read More