Enterprise risk management

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Enterprise risk management (ERM) in business includes the methods and processes used by organizations to manage risks and seize opportunities related to the achievement of their objectives. ERM provides a framework for risk management, which typically involves identifying particular events or circumstances relevant to the organization's objectives (risks and opportunities), assessing them in terms of likelihood and magnitude of impact, determining a response strategy, and monitoring progress. By identifying and proactively addressing risks and opportunities, business enterprises protect and create value for their stakeholders, including owners, employees, customers, regulators, and society overall.

ERM can also be described as a risk-based approach to managing an enterprise, integrating concepts of strategic planning, operations management, and internal control. ERM is evolving to address the needs of various stakeholders, who want to understand the broad spectrum of risks facing complex organizations to ensure they are appropriately managed. Regulators and debt rating agencies have increased their scrutiny on the risk management processes of companies.


[edit] ERM frameworks defined

There are various important ERM frameworks, each of which describe an approach for identifying, analyzing, responding to, and monitoring risks and opportunities, within the internal and external environment facing the enterprise. Management selects a risk response strategy for specific risks identified and analyzed, which may include:

  1. Avoidance: exiting the activities giving rise to risk
  2. Reduction: taking action to reduce the likelihood or impact related to the risk
  3. Share or insure: transferring or sharing a portion of the risk, to reduce it
  4. Accept: no action is taken, due to a cost/benefit decision

Monitoring is typically performed by management as part of its internal control activities, such as review of analytical reports or management committee meetings with relevant experts, to understand how the risk response strategy is working and whether the objectives are being achieved.

[edit] Casualty Actuarial Society framework

In 2003, the Casualty Actuarial Society (CAS) defined ERM as "…the discipline by which an organization in any industry assesses, controls, exploits, finances, and monitors risks from all sources for the purpose of increasing the organization's short- and long-term value to its stakeholders."[1] The CAS conceptualized ERM as proceeding across the two dimensions of risk type and risk management processes.[1] The risk types and examples include:[2]

Hazard risk
Liability torts, Property damage, Natural catastrophe
Financial risk
Pricing risk, Asset risk, Currency risk, Liquidity risk
Operational risk
Customer satisfaction, Product failure, Integrity, Reputational risk
Strategic risks
Competition, Social trend, Capital availability

The risk management process involves:[3]

  1. Establishing Context: This includes an understanding of the current conditions in which the organization operates on an internal, external and risk management context.
  2. Identifying Risks: This includes the documentation of the material threats to the organization’s achievement of its objectives and the representation of areas to the organization may exploit for competitive advantage.
  3. Analyzing/Quantifying Risks: This includes the calibration and, if possible, creation of probability distributions of outcomes for each material risk.
  4. Integrating Risks: This includes the aggregation of all risk distributions, reflecting correlations and portfolio effects, and the formulation of the results in terms of impact on the organization’s key performance metrics.
  5. Assessing/Prioritizing Risks: This includes the determination of the contribution of each risk to the aggregate risk profile, and appropriate prioritization.
  6. Treating/Exploiting Risks: This includes the development of strategies for controlling and exploiting the various risks.
  7. Monitoring and Reviewing: This includes the continual measurement and monitoring of the risk environment and the performance of the risk management strategies.

[edit] COSO ERM framework

The COSO "Enterprise Risk Management-Integrated Framework" published in 2004 defines ERM as a "…process, effected by an entity's board of directors, management, and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives."[4]

The COSO ERM Framework has eight Components and four objectives categories. It is an expansion of the COSO Internal Control-Integrated Framework published in 1992 and amended in 1994. The eight components - additional components highlighted - are:

  • Internal Environment
  • Objective Setting
  • Event Identification
  • Risk Assessment
  • Risk Response
  • Control Activities
  • Information and Communication
  • Monitoring

The four objectives categories - additional components highlighted - are:

  • Strategy - high-level goals, aligned with and supporting the organization's mission
  • Operations - effective and efficient use of resources
  • Financial Reporting - reliability of operational and financial reporting
  • Compliance - compliance with applicable laws and regulations

[edit] RIMS risk maturity model for enterprise risk management

Enterprise risk management as defined by the Risk and Insurance Management Society (RIMS) is the culture, processes and tools to identify strategic opportunities and reduce uncertainty. ERM is a comprehensive view of risk from both operational and strategic perspectives and is a process that supports the reduction of uncertainty and promotes the exploitation of opportunities.

According to the RIMS Risk Maturity Model for ERM,[5] the following seven core competencies, or attributes, measure how well enterprise risk management is embraced by management and ingrained within the organization. A maturity level is determined for each attribute and ERM maturity is determined by the weakest link.

1. ERM-based approach - Degree of executive support for an ERM-based approach within the corporate culture. This goes beyond regulatory compliance across all processes, functions, business lines, roles and geographies. Degree of integration, communication and coordination of internal audit, information technology, compliance, control and risk management.

2. ERM process management - Degree of weaving the ERM Process into business processes and using ERM Process steps to identify, analyze, evaluate, mitigate and monitor. Degree of incorporating qualitative methods supported by quantitative methods, analysis, tools.

3. Risk appetite management – Degree of understanding the risk-reward tradeoffs within the business. Accountability within leadership and policy to guide decision-making and attack gaps between perceived and actual risk. Risk appetite defines the boundary of acceptable risk and risk tolerance defines the variation of measuring risk appetite that management deems acceptable.

4. Root cause discipline - Degree of discipline applied to measuring a problem’s root cause and binding events with their process sources to drive the reduction of uncertainty, collection of information and measurement of the controls’ effectiveness. The degree of risk from people, external environment, systems, processes and relationships is explored.

5. Uncovering risks - Degree of quality and penetration coverage of risk assessment activities in documenting risks and opportunities. Degree of collecting knowledge from employee expertise, databases and other electronic files (such as Microsoft Word, Excel, etc) to uncover dependencies and correlation across the enterprise.

6. Performance management - Degree of executing vision and strategy, working from financial, customer, business process and learning and growth perspectives, such as Kaplan’s balanced scorecard, or similar approach. Degree of exposure to uncertainty, or potential deviations from plans or expectations.

7. Business resiliency and sustainability – Extent to which the ERM Process’s sustainability aspects are integrated into operational planning. This includes evaluating how planning supports resiliency and value. The degree of ownership and planning beyond recovering technology platforms. Examples include vendor and distribution dependencies, supply chain disruptions, dramatic market pricing changes, cash flow volatility, business liquidity, etc.

[edit] Implementing an ERM program

[edit] Goals of an ERM program

Organizations by nature manage risks and have a variety of existing specialized departments or functions ("risk functions") that identify and manage particular risks. However, each risk function varies in capability and how it coordinates with other risk functions. A central goal and challenge of ERM is improving this capability and coordination, while integrating the output to provide a unified picture of risk for stakeholders and improving the organization's ability to manage the risks effectively.

[edit] Typical risk functions

The primary risk functions in large corporations that may participate in an ERM program typically include:

  • Strategic planning - identifies external threats and competitive opportunities, along with strategic initiatives to address them
  • Marketing - understands the target customer to ensure product/service alignment with customer requirements
  • Compliance & Ethics - monitors compliance with code of conduct and directs fraud investigations
  • Accounting / Financial compliance - directs the Sarbanes-Oxley Section 302 and 404 assessment, which identifies financial reporting risks
  • Law Department - manages litigation and analyzes emerging legal trends that may impact the organization
  • Insurance - ensures the proper insurance coverage for the organization
  • Treasury - ensures cash is sufficient to meet business needs, while managing risk related to commodity pricing or foreign exchange
  • Operational Quality Assurance - verifies operational output is within tolerances
  • Operations management - ensures the business runs day-to-day and that related barriers are surfaced for resolution
  • Credit - ensures any credit provided to customers is appropriate to their ability to pay
  • Customer service - ensures customer complaints are handled promptly and root causes are reported to operations for resolution
  • Internal audit - evaluates the effectiveness of each of the above risk functions and recommends improvements

[edit] Common challenges in ERM implementation

Various consulting firms offer suggestions for how to implement an ERM program.[6] Common topics and challenges include[7]:

  • Identifying executive sponsors for ERM.
  • Establishing a common risk language or glossary.
  • Describing the entity's risk appetite (i.e., risks it will and will not take)
  • Identifying and describing the risks in a "risk inventory".
  • Implementing a risk-ranking methodology to prioritize risks within and across functions.
  • Establishing a risk committee and or Chief Risk Officer (CRO) to coordinate certain activities of the risk functions.
  • Establishing ownership for particular risks and responses.
  • Demonstrating the cost-benefit of the risk management effort.
  • Developing action plans to ensure the risks are appropriately managed.
  • Developing consolidated reporting for various stakeholders.
  • Monitoring the results of actions taken to mitigate risk.
  • Ensuring efficient risk coverage by internal auditors, consulting teams, and other evaluating entities.
  • Developing a technical ERM framework that enables secure participation by 3rd parties and remote employees.

[edit] Internal audit role

In addition to information technology audit, Internal Auditors play an important role in evaluating the risk management processes of an organization and advocating their continued improvement. However, to preserve its organizational independence and objective judgment, Internal Audit professional standards indicate the function should not take any direct responsibility for making risk management decisions for the enterprise or managing the risk management function. [8]

Internal auditors typically perform an annual risk assessment of the enterprise, to develop a plan of audit engagements for the upcoming year. This plan is updated at various frequencies in practice. This typically involves review of the various risk assessments performed by the enterprise (e.g., strategic plans, competitive benchmarking, and SOX top-down risk assessment), consideration of prior audits, and interviews with a variety of senior management. It is designed for identifying audit projects, not to identify, prioritize, and manage risks directly for the enterprise.

[edit] Current issues in ERM

The risk management processes of U.S. corporations are under increasing regulatory and private scrutiny. Risk is an essential part of any business. Properly managed, it drives growth and opportunity. Executives struggle with business pressures that may be partly or completely beyond their immediate control, such as distressed financial markets; mergers, acquisitions and restructurings; disruptive technology change; geopolitical instabilities; and the rising price of energy..

[edit] Sarbanes-Oxley Act requirements

Section 404 of the Sarbanes-Oxley Act of 2002 required U.S. publicly-traded corporations to utilize a control framework in their internal control assessments. Many opted for the COSO Internal Control Framework, which includes a risk assessment element. In addition, new guidance issued by the Securities and Exchange Commission (SEC) and PCAOB in 2007 placed increasing scrutiny on top-down risk assessment and included a specific requirement to perform a fraud risk assessment.[9] Fraud risk assessments typically involve identifying scenarios of potential (or experienced) fraud, related exposure to the organization, related controls, and any action taken as a result.

[edit] NYSE corporate governance rules

The New York Stock Exchange requires the Audit Committees of its listed companies to "discuss policies with respect to risk assessment and risk management." The related commentary continues: "While it is the job of the CEO and senior management to assess and manage the company’s exposure to risk, the audit committee must discuss guidelines and policies to govern the process by which this is handled. The audit committee should discuss the company’s major financial risk exposures and the steps management has taken to monitor and control such exposures. The audit committee is not required to be the sole body responsible for risk assessment and management, but, as stated above, the committee must discuss guidelines and policies to govern the process by which risk assessment and management is undertaken. Many companies, particularly financial companies, manage and assess their risk through mechanisms other than the audit committee. The processes these companies have in place should be reviewed in a general manner by the audit committee, but they need not be replaced by the audit committee."[10]

[edit] ERM and corporate debt ratings

Standard & Poor's (S&P), the debt rating agency, plans to include a series of questions about risk management in its company evaluation process. This will rollout to financial companies in 2007.[11] The results of this inquiry is one of the many factors considered in debt rating, which has a corresponding impact on the interest rates lenders charge companies for loans or bonds.[12] On May 7, 2008 S&P also announced that it would begin including an ERM assessment in its ratings for non-financial companies starting in 2009[13], with initial comments in its reports during Q4 2008.[14]

[edit] Emerging Standards

ISO 31000 is an International Standard for Risk Management, which is presently a draft. It represents some of the current thinking on risk management. It is supported by a Glossary and a Risk Methodology compilation.

[edit] Actuarial response

[edit] Casualty Actuarial Society

In 2003, the Enterprise Risk Management Committee of the Casualty Actuarial Society (CAS) issued its overview of ERM.[15] This paper laid out the evolution, rationale, definitions, and frameworks for ERM from the casualty actuarial perspective, and also included a vocabulary, conceptual and technical foundations, actual practice and applications, and case studies.[15]

The CAS has specific stated ERM goals, including being "a leading supplier internationally of educational materials relating to Enterprise Risk Management (ERM) in the property casualty insurance arena,"[16] and has sponsored research, development, and training of casualty actuaries in that regard.[17] The CAS has refrained from issuing its own credential; instead, in 2007, the CAS Board decided that the CAS should participate in the initiative to develop a global ERM designation, and make a final decision at some later date.[18]

[edit] Society of Actuaries

In 2007, the Society of Actuaries developed the Chartered Enterprise Risk Analyst (CERA) credential in response to the growing field of enterprise risk management.[19] This is the first new professional credential to be introduced by the SOA since 1949.[20] A CERA studies to focus on how various risks, including operational, investment, strategic, and reputational combine to affect organizations. CERAs work in environments beyond insurance, reinsurance and the consulting markets, including broader financial services, energy, transportation, media, technology, manufacturing and healthcare.[20]

It takes approximately three to four years to complete the CERA curriculum which combines basic actuarial science, ERM principles and a course on professionalism. To earn the CERA credential, candidates must take five exams, fulfill an educational experience requirement, complete one online course, and attend one in-person course on professionalism.[20] CERAs are members of the Society of Actuaries.[21]

[edit] Companies Increasingly Focusing on ERM

It is clear that companies recognize ERM as a critical management issue. This is demonstrated through the prominence assigned to ERM within organizations and the resources devoted to building ERM capabilities. In a 2008 survey by Towers Perrin[22], at most life insurance companies, responsibility for ERM resides within the C-suite. Most often, the chief risk officer (CRO) or the chief financial officer (CFO) is in charge of ERM, and these individuals typically report directly to the chief executive officer. From their vantage point, the CRO and CFO are able to look across the organization and develop a perspective on the risk profile of the firm and how that profile matches its risk appetite. They act as drivers to improve skills, tools and processes for evaluating risks and to weigh various actions to manage those exposures. Companies are also actively enhancing their ERM tools and capabilities. Three quarters of responding companies said they have tools for specifically monitoring and managing enterprise-wide risk. These tools are used primarily for identifying and measuring risk and for management decision making. Respondents also reported that they have made good progress in building their ERM capabilities in certain areas.

In this study, more than 80% of respondents reported that they currently have adequate or better controls in place for most major risks. In addition, about 60% currently have a coordinated process for risk governance and include risk management in decision making to optimize risk adjusted returns.

In another survey conducted in May and June 2008, against the backdrop of the developing financial crisis, six major findings came to light regarding risk and capital management among insurers worldwide:[23]

  • Embedding ERM is proving to be a significant challenge
  • Company size matters
  • European insurers are better positioned
  • ERM is influencing important strategic decisions
  • Economic capital standards are gaining ground
  • Operational risk remains a weak spot

[edit] References

  1. ^ a b Enterprise Risk Management Committee (May 2003) (PDF). Overview of Enterprise Risk Management. Casualty Actuarial Society. pp. p.8. http://www.casact.org/research/erm/overview.pdf. Retrieved on 2008-09-15. 
  2. ^ Enterprise Risk Management Committee (May 2003) (PDF). Overview of Enterprise Risk Management. Casualty Actuarial Society. pp. pp.9–10. http://www.casact.org/research/erm/overview.pdf. Retrieved on 2008-09-15. 
  3. ^ Enterprise Risk Management Committee (May 2003) (PDF). Overview of Enterprise Risk Management. Casualty Actuarial Society. pp. pp.11–13. http://www.casact.org/research/erm/overview.pdf. Retrieved on 2008-09-15. 
  4. ^ (PDF)Enterprise Risk Management — Integrated Framework: Executive Summary. Committee of Sponsoring Organizations of the Treadway Commission. September 2004. http://www.coso.org/Publications/ERM/COSO_ERM_ExecutiveSummary.pdf. Retrieved on 2008-09-16. 
  5. ^ Risk and Insurance Management Society (RIMS)
  6. ^ ERM Implementation Advice
  7. ^ ERM Frequently Asked Questions
  8. ^ Role of Internal Auditing in ERM
  9. ^ PCAOB Auditing Standard No 5
  10. ^ NYSE Listing Standards Part 7d
  11. ^ S&P Ratings - Treasury & Risk Article
  12. ^ S&P ERM for Financial Institutions
  13. ^ S&P ERM FAQs
  14. ^ S&P ERM Announcement
  15. ^ a b Enterprise Risk Management Committee (May 2003) (PDF). Overview of Enterprise Risk Management. Casualty Actuarial Society. http://www.casact.org/research/erm/overview.pdf. Retrieved on 2008-09-15. 
  16. ^ "ERM SAM Goals" (PDF). CAS Centennial Goal and SAM Goals. Casualty Actuarial Society. March 2008. http://www.casact.org/about/ERM_SAMs.pdf. Retrieved on 2008-09-15. 
  17. ^ "Enterprise Risk Management Web Site". Casualty Actuarial Society. 2008. http://www.casact.org/research/erm/. Retrieved on 2008-09-15. 
  18. ^ "Executive Summary: CAS Board of Directors Meeting" (PDF). Casualty Actuarial Society. June 17, 2007. http://www.casact.org/about/governance/bod/061707ES.pdf. Retrieved on 2008-09-15. 
  19. ^ "Credential Overview". Society of Actuaries. 2008. http://www.ceranalyst.org/overview.asp. Retrieved on 2008-09-15. 
  20. ^ a b c "CERA Fast Facts". Society of Actuaries. 2008. http://www.ceranalyst.org/cera-facts-overview.asp. Retrieved on 2008-09-15. 
  21. ^ "Benefits". Society of Actuaries. 2008. http://www.ceranalyst.org/benefits.asp. Retrieved on 2008-09-15. 
  22. ^ Embedding Enterprise Risk Management Towers Perrin
  23. ^ 2008 Global Insurance Industry ERM Survey Report Towers Perrin

[edit] See also

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