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Finance 590 Enterprise Risk Management

Finance 590 Enterprise Risk Management. Steve D’Arcy Department of Finance Lecture 1 March 15, 2005. What is ERM?. ERM is the application of the basic risk management principles to all risks facing an organization Other names for ERM Enterprise-wide risk management

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Finance 590 Enterprise Risk Management

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  1. Finance 590Enterprise Risk Management Steve D’ArcyDepartment of Finance Lecture 1 March 15, 2005

  2. What is ERM? ERM is the application of the basic risk management principles to all risks facing an organization Other names for ERM Enterprise-wide risk management Holistic risk management Integrated risk management Strategic risk management Global risk management

  3. ERM FeaturesCulp - 2002 • Consolidates risk exposures and identifies core and non-core risks • Views risk through common lens • Coordinates risk management process organizationally • Systems • Processes • People • Innovates

  4. Protecting Value Study 2004 • Sponsored by FM Global • Mutual commercial property insurer • Headquartered in Johnston, RI • Conducted by Harris Interactive • Surveyed over 600 • CFOs and treasurers • Risk managers • Investment professionals • US and Europe

  5. Survey Results • ERM should be a board level issue • 90% CFOs, Treasurers and Risk Managers • 93% Investment Professionals • ERM is a board level issue • 65% US • 93% Europe

  6. Top Revenue Drivers

  7. Top Hazard to Company’s Top Revenue Driver

  8. Basic Risk Management Principles • Identifying loss exposures • Measuring loss exposures • Evaluating the different methods for handling risk • Risk assumption • Risk transfer • Risk reduction • Selecting a method • Monitoring results

  9. Why Manage Risk? Diversifiable risk argument • Shareholders are diversified investors • They will not pay a premium to reduce unsystematic risk How risk management can add value • Decreasing taxes • Decreasing the cost of financial distress • Customers • Employees • Suppliers • Facilitating optimal investment • Increasing firm value

  10. Where Did ERM Come From? Traditional risk management Formally developed as a field in the 1960s Focused on “pure” risks Loss/no loss situation Often could be insured Developed from insurance purchasing area

  11. New Elements of Risk – 1970s Foreign exchange risk End of Bretton Woods agreement in 1972 Commodity price risk Oil price fluctuations of the 1970s Equity risk Development of option markets - 1973 Interest rate risk Federal Reserve Board policy shift - 1979

  12. Failure to Manage Financial Risk • Foreign exchange risk • Laker Airlines – 1970s • Borrowing in dollars • Revenue in pounds • Interest rate risk • U. S. Savings and Loans – 1980s • Borrowing short • Lending long • Commodity price risk • Continental Airlines – 1990 • Fuel costs not hedged • Oil price doubled with Gulf War

  13. The “New” Risk Management -1980s Financial risk management Dealt with financial risk Foreign exchange risk Interest rate risk Equity risk Commodity price risk Use derivatives to hedge financial risk

  14. Financial Risk Management Toolbox • Forwards • Futures • Options • Swaps

  15. New Elements of Risk – 1990s • Failure to manage derivatives appropriately • Financial model failures • Improper accounting for derivatives

  16. Mismanagement of Financial Risk • Mismanagement of derivatives • Gibson Greetings • Proctor and Gamble • Barings Bank • Orange County • Model failure • Long Term Capital • Accounting improprieties • Enron • Cedant • Arthur Andersen

  17. The “New” Risk Management - 1990s and beyond • Enterprise Risk Management • Initial focus on avoiding derivative disasters • Developing into optimizing firm value • Chief Risk Officer • Sarbanes-Oxley Act – 2002 • Increased focus on risk models

  18. Components of ERMLam 1999 • Corporate governance • Line management • Portfolio management • Risk transfer • Risk analytics • Data and technology resources • Stakeholder management

  19. ERM Risk Categories Common risk allocation • Hazard risk • Financial risk • Operational risk • Strategic risk Bank view – New Basel Accord • Credit risk • Loan and counterparty risk • Market risk (financial risk) • Operational risk

  20. Hazard Risk • “Pure” loss situations • Property • Liability • Employee related • Independence of separate risks • Risks can generally be handled by • Insurance, including self insurance • Avoidance • Transfer

  21. Financial Risk • Components • Foreign exchange rate • Equity • Interest rate • Commodity price • Correlations among different risks • Use of hedges, not insurance or risk transfer • Securitization

  22. Operational Risk Causes of operational risk • Internal processes • People • Systems Examples • Product recall • Customer satisfaction • Information technology • Labor dispute • Management fraud

  23. Strategic Risk Examples • Competition • Regulation • Technological innovation • Political impediments

  24. Enterprise Risk Management Infrastructure • Analytics • Valuation models • Simulation models • Data sets • Risk information • Transactions • Internal data (customers, risk limits, products) • Market data • Reliable communications • Operations • Impact of technology

  25. Evolution of ERM • Control function • How much can we lose? • Risk adjusted returns • Capital allocation • Compensation • Bonuses • Optimization • Maximize shareholder value • Vision of the future

  26. Impediments to Effective ERM • Risk models and technology • Organization • Motivation • Operating infrastructure • Data problems • Regional fiefdoms • High failure rate of IT projects

  27. Increased Use of Risk Models • Technological advances • Theoretical advances • Allocation of economic capital • Used for divisional profitability • Impacts bonuses • Dueling models

  28. Chief Risk Officer • Reports to CFO, CEO or Board • Responsible for managing all aspects of risk • Understand technology • Communication skills

  29. Traditional Risk Management Silos • Financial risk – Treasury • Insurance risk – Risk Management • Operational risk – Business units

  30. How ERM Can Increase Firm Value • Process can focus on protecting • Value • Cash flows • Earnings • Cannot protect all three at once • Examples • Reducing taxes is earnings based strategy • Insuring to prevent assets from declining is value based • Hedging to maintain internal funding sources is cash flow based

  31. Increasing Firm Value V = Σ FCFt / (1+k)t V = Firm value FCF = Free cash flow k = cost of capital Decreasing the volatility of future cash flows can decrease the cost of capital

  32. Risk Structure • Risk map • Frequency • Severity • Capital structure • Capital efficiency • Equity – capital adequacy • Debt – financial leverage • Insurance – risk leverage

  33. Corporate Structure • CFO – capital management • CRO – risk management • Define risk • Gather information • Use information • No consistent risk framework in place yet • Need for risk balance sheet/income statement approach • Control risk • Increase firm value

  34. Essential Skills of a Risk ManagerFalkenstein - 2001 • Understand benefits and limitations of models • Comprehension of data gathering process • Identifying essential data • Gathering information into central location • Interpreting reports • Ability to focus on key risks • Communication skills

  35. Knowledge Base for Risk Manager • Technical tools used in risk analysis • Data integration expertise • Understanding of how risk measures relate to strategic and tactical business decisions

  36. Examples of ERM - 1 Michelin – contingent capital • Issued by Swiss Re New Markets and Societe Generale • Option to draw on subordinated long-term bank credit facility • Option to issue subordinated debt at fixed spread • This option can only be exercised if GDP growth falls below a trigger (1.5% 2001-03, 2.0% 2004-05)

  37. Examples of ERM - 2 United Grain Growers – risk integration • Issued by Swiss Re • Grain volume coverage • Integrated with other property/liability coverages • Three year policy • Annual aggregate retention • $35 million annual limit • $80 million policy limit

  38. Examples of ERM - 3 RLI Corporation – Cat-E-Puts • Arranged by Aon, issued by Centre Re • Three year term • Provided an option to issue $50 million in convertible preferred shares • Trigger was major California earthquake • Subject to minimum capital requirements

  39. Future of ERM • ERM will continue as risk consolidation and aggregation • Process increases value of risk management skills • Management is concerned with risk control issues • Chief Risk Officer will be a visible figure in an organization • Many paths to CRO, diverse skills required • ERM’s role in optimization has a long way to go • Potential benefit is worth pursuing for pioneers

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