Enterprise risk management (ERM) projects often fail to achieve their potential value. In many cases, the full measure of that value is never even recognized. That is because most discussions of ERM tell only half of the story—the half that’s about preparing for and protecting against risks that can threaten the solvency of an enterprise. This is certainly a worthy goal. Companies that analyze and plan for "tail" risk are better able to preserve their value in the long term than those who don't. But focusing exclusively on value preservation misses an even more compelling opportunity—to use ERM to create operational and financial advantages by optimizing assets, balancing product lines, introducing risk-aware governance, and more.
Applied in this way, ERM becomes a tool for maximizing the ability of insurance companies (or any enterprise) to take on risk-bearing profit opportunities. Instead of solely quantifying the minimum level of required capital to prevent insolvency at certain confidence levels, ERM as value creator optimally allocates scarce resources (including capital) to enable companies to take advantage of the maximum number of business opportunities. At its best, ERM improves decision making, helps to increase the company's value, and balances risks in the most resource-efficient ways.
We start with a definition of ERM that includes its role in the creation of value: Enterprise risk management is a comprehensive, distributed framework for the risk-conscious deployment of capital in localized decision making.
In practice, this definition of ERM leads to a distinct approach with identifiable features. It is:
- Distributed: With this definition, we immediately expand the field of ERM from a narrow group of executives or specialists to many of the people who make up the organization. In this approach, ERM is designed as a mechanism to support good business decisions throughout the company. That enables risk management to be proactive rather than reactive. Using ERM only at the highest levels of decision making robs the discipline of much of its power to create and preserve value. Every day, every product-design, marketing, operational, or financial decision that is made has the potential to affect a company’s risk position. Risk awareness should be distributed throughout an organization so that it can have the most beneficial impact on the hundreds of daily choices that make up the real life of a company. This allows risks to be managed at the moment rather than tallied up after the fact. More importantly, adopting a distributed approach is the first step toward transforming ERM into a value creator, as it incentivizes and empowers people to make the best possible decisions.
- Information-driven: One of the central goals of ERM is to widen the range of risks that an organization considers. If risk-influenced decision making is distributed, it must also be accompanied by a comprehensive picture of companywide risks. Managers attempting to make risk-conscious decisions without a full complement of information are still shooting in the dark. Therefore, they must have the means to gather that information and a framework for interpreting and communicating it. Here is another instance of ERM as value creator: It encourages the company to adopt systems that give people the information they need to make the right decisions.
- Operationally integrated: Making the best decisions in light of enterprise risk is not easy; in fact, not everyone will have the knowledge or skill to make those decisions. Operationally, a value-driven ERM framework looks very different from a system with a siloed approach. Value-driven ERM must be supported by a strong governance framework that guides and monitors the actions of every decision maker. That framework consists of ERM policies and procedures that can be followed by individuals throughout the organization; roles, responsibilities, and reporting structures to create accountability for implementing the policies and procedures; and the establishment of best practices, expressed as operational controls and guidelines. These structures must be responsive to changing company and market conditions if they are to avoid ossifying into a rigid system that does more harm than good.
They must also be aligned with corporate culture to ensure observance and adherence.
The result is a way of doing ERM that goes beyond the remediation of risk exposures to enable the following:
- Empowerment, giving people the information, authority, and structure they need to make the best, most organizationally aware decisions.
- Discernment, giving decision makers the perspective they need to seek comparative context among the broad range of risks (both financial and non-financial) they face.
- Conviction, increasing the confidence with which companies determine and deploy correct levels of risk capital in light of balance sheet interactions.
- Consensus, helping partners, customers, and regulators understand and support decisions that affect risk.
Economic capital
Economic capital (EC) models are central to ERM. In keeping with our definition of ERM as a means to create value by distributing risk awareness and decision making throughout an enterprise, we define economic capital thus: Economic capital is the balance sheet power that ensures the long-range economic vitality of the enterprise and its ability to seize risk-bearing profit opportunities.
The first part of this definition is the one that is discussed most often. EC is characterized as a better, more sophisticated way to measure the resources necessary to ensure solvency in tail-risk situations. The second half is what distinguishes value-driven ERM from other approaches: ERM is a means to maximize opportunity and value in a risky world. Understanding resource needs under extreme conditions is part of the equation; understanding how risks are interrelated and can exacerbate or offset one another completes it.
Value-driven ERM asks EC to answer more sophisticated questions than "How much risk capital do we need to set aside?" As with ERM in general, EC should inform decision making at the level of individual projects and products on a daily basis. Two questions that permit EC this enlarged role are:
- What is the economic return on a prospective project in relation to the risk capital it commands? By its nature, an EC model can quantify the relationship between a specific project and the enterprise’s existing risk profile. Using EC in this way enables a company to evaluate projects based on consistent, coherent, and comparable criteria. If a project will unfavorably affect risk capital profiles, it can be modified or abandoned.
- What is the optimal arrangement of assets and liabilities given my business situation and appetite for risk? By using EC to answer this question, the range of potential solutions to a given risk situation is broadened. Instead of merely abandoning a risk-bearing project, EC enables decision makers to contemplate how they can mitigate risk through shifting investments and products that balance one another. EC does this by objectively determining how product-line and asset interactions add or destroy value. The goal is to optimize the asset/liability portfolio to maximize the ratio of project value to required capital.
The right tools for the job
Discussions of ERM tend to become opaque rather quickly, and it is not our intention to cloud already murky waters. Our unique approach to ERM arises from experience in the field, watching companies implement ERM tools in ways that add to the burden of management without creating value for the organization beyond regulatory compliance. When ERM is implemented as an empirical, enterprise-wide, governance-conscious system, it can create an operational environment that allows a company to maximize opportunity, minimize misallocated capital, and help to ensure solvency in tail-risk scenarios.
The diagram on this page maps the movement of the ERM process through the organization. This diagram graphically represents the assertion that good ERM drives two types of initiatives: analytical (risk assessment) and operational (good governance). Analysis alone can help address balance sheet issues but cannot effect operational change, which is crucial for minimizing tail risk, enhancing returns, and demonstrating risk awareness to ratings agencies and the marketplace. Operational change in the absence of numeric analysis can create more risk than it ameliorates, especially in the financial and insurance industries, where risks and the relationships among them are complex and interrelated.
On the other hand, when operational and analytical ERM initiatives work together under the guiding principle of value creation, the results can be transformative. Integrated, distributed, profit-focused ERM can give companies real competitive advantages both immediately and in the long term. The key is to stop seeing ERM as compliance drudgery or a cost center and start seeing it for what it is: a tool for making better decisions.
Jay Glacy is a senior consultant in the Chicago office of Milliman. He focuses his efforts in the area of enterprise risk management, helping clients balance total risk exposures and optimize their deployment of risk capital. He has specific expertise in enterprise risk management, strategic asset allocation, strategic capital deployment, asset/liability management, and capital markets risk management.