« About Madhu Acharyya |
Main
| New research finds no explicit relation of insurers ERM practice with their stock market performance »
April 18, 2008
The value of ERM - some research findings
Why should a firm practice Enterprise Risk Management (ERM)? Where are the benefits? How to demonstrate them? These are the tough questions that the risk management professionals are facing today.
Previous researches on Corporate Risk Management (CRM) suggest that firms should engage in risk management (i.e., hedging). The benefits are implicit i.e., reduction of bankruptcy cost, lower tax, higher borrowing capacity, etc. There is no established evidence that suggests the tangible benefits of managing risks (e.g., increase of share price). However, ERM fundamentally differs with CRM in many aspects. Theoretically, ERM intends to see the firm as a whole beyond disciplinary silos or boundaries. It includes the elements of human and market irrationality in the hard measures of risk. This introduces the complexities in ERM researches.
Indeed, the ultimate objective of the [financial] firms is to make profit, which in modern terminology called 'value'. From the perspective of finance theories, every action of the management should be aligned with this overriding objective (i.e., maximization of shareholder value). ERM is not an exception. A research was carried out with four major European insurers to see how they demonstrate the value of their ERM. The results indicate that although their conceptual understanding on ERM is somehow consistent, the best practice of ERM is yet to evolve. However, one of the key cornerstones of ERM is the economic capital, which theoretically reflects the total [economic] risk of the firm. The research finds that the demonstration of value of ERM is complex since its close association with the corporate [finance] functions. Every corporate action involves risk and it is difficult to separate risk management from the management of business either in part or as a whole. Consequently, the study concluded that the value of ERM is integrated with the value of the entire firm. Alternatively, the performance of ERM should be evaluated with the performance of the entire firm. The study also revealed that a well designed ERM can not guarantee the success of the firm. This is because ERM is a system which includes policies, processes, and arrangements embedded at all parts of the firm. These are heavily exposed to the strength of appropriate human actions. If the firm does not have adequate expertise, intelligence and importantly the willingness to enforce ERM, it may not demonstrate the expected value.
Academically speaking, the ERM is truly a multidisciplinary subject which includes the integration of the knowledge from financial economics and strategic management. Practically, ERM needs the aggregation of the techniques of corporate finance and corporate governance. Indeed, the ERM practicing firms enjoy some short-term benefits which are often awarded by third parties such as recognition of regulators (e.g., Solvency or Risk Based Capital) and rating agencies (e.g., superior financial ratings). However, the long term benefits of ERM are mostly intangible (e.g., reputation). Finally, ERM is to achieve the corporate objectives of individual firms.
Posted by madhuacharyya at April 18, 2008 06:28 AM
Thank you for this....do you have a link to the ERM study you mention in your post?
The notion that ERM and the business cannot be separated is essential for ERM to achieve its potential. We work on eliminating silos in risk management, but often create a new silo in the business called 'risk management'. We should break down that silo too.
Posted by: David Koenig at April 23, 2008 06:48 PM
Madhu,
I enjoyed reading your comments about ERM and its focus. Certainly now, more than ever, the focus has shifted to risk measurement. In my view, every enterprise needs to understand the "core" risks it is exposed to and how it should seek to measure and manage it. A risk framework should really be triangulation of empirical evidence, expert input, robust mathematical modelling and any any understanding that can be elicited from stress testing (i.e. so called tail behaviour). At the end of the day any framework will only be effective if it drives behaviours that are in line with the organisatio's risk appetite.
My focus has been on understanding the dynamics of reputational risk; primary or secondary risk?; how to measure it? and is capital required to cover it?. The realms of belief formation within stakeholders is an interesting area.
Posted by: Ram Ananth at April 25, 2008 02:49 PM
Post a comment
