Chapter 5 The Evolution of Risk Management: Enterprise Risk Management

Maximization of Firm’s Value for Sustainability

Another significant change in a way that firms are valued is the special attention that many are giving to general environmental considerations. A case in point is the issue of fuel and energy. In the summer of 2008, the cost of gas rising to over $150 a barrel and consumers paying more than $4 at the pump for a gallon of gas, alternatives have emerged globally. At the time of writing this textbook, the cost of gas had dropped significantly to as low as $1.50 per gallon at the pump, but the memory of the high prices, along with the major financial crisis, is a major incentive to production of alternative energy sources such as wind and sun. Fuel cost contributed in large part to the trouble that the U.S. automakers faced in December because they had continued to produce large gas-guzzlers such as sport-utility vehicles (SUVs) with minimal production of alternative gas-efficient cars like the Toyota Prius and Yaris, the Ford Fusion hybrid, and the Chevrolet Avio. With the U.S. government bailout of the U.S. automobile industry in December 2008 came a string of demands to modernize and to innovate with electric cars. Further, the government made it clear that Detroit must produce competitive products already offered by the other large automakers such as Toyota and Honda (which offered both its Accord and its Civic in hybrid form).See references to Capital versus Risks studies such as Etti G. Baranoff and Thomas W. Sager, “The Impact of Mortgage-backed Securities on Capital Requirements of Life Insurers in the Financial Crisis of 2007–2008,” Geneva Papers on Risk and Insurance Issues and Practice, The International Association for the Study of Insurance Economics 1018–5895/08, http://www.palgrave-journals.com/gpp; Etti G. Baranoff, Tom W. Sager, and Savas Papadopoulos, “Capital and Risk Revisited: A Structural Equation Model Approach for Life Insurers,” Journal of Risk and Insurance, 74, no. 3 (2007): 653–81; Etti G. Baranoff and Thomas W. Sager, “The Interrelationship among Organizational and Distribution Forms and Capital and Asset Risk Structures in the Life Insurance Industry,” Journal of Risk and Insurance 70, no. 3 (2003): 375; Etti G. Baranoff and Thomas W. Sager, “The Relationship between Asset Risk, Product Risk, and Capital in the Life Insurance Industry,” Journal of Banking and Finance 26, no. 6 (2002): 1181–97. Chevrolet will offer a plug-in car called the Volt in the spring of 2010 with a range of more than 80 mpg on a single charge. Chrysler and Ford plan to follow with their own hybrids by 2012.

World population growth and fast growth among emerging economies have led us to believer that our environment has suffered immense and irrevocable damage.See environmental issues at http://environment.about.com/b/2009/01/20/obama-launches-new-white-house-web-site-environment-near-the-top-of-his-agenda .htm, http://environment.about.com/b/2009/01/12/billions-of-people-face-food-shortages-due-to-global-warming.htm, or http://environment.about.com/b/2009/01/20/obamas-first-100-days-an-environmental-agenda-for-obamas-first-100-days.htm. Its resources have been depleted; its atmosphere, land, and water quickly polluted; and its water, forests, and energy sources destroyed. The 2005 United Nations Millennium Ecosystem report from 2005 provides a glimpse into our ecosystem’s fast destruction. From a risk management point of view, these risks can destroy our universe, so their management is essential to sustainabilityThe capacity to maintain a certain process or state.. Sustainability, in a broad sense, is the capacity to maintain a certain process or state. It is now most frequently used in connection with biological and human systems. In an ecological context, sustainability can be defined as the ability of an ecosystem to maintain ecological processes and functions.http://en.wikipedia.org/wiki/Sustainability. Some risk management textbooks regard the risk management for sustainability as the first priority, since doing business is irrelevant if we are destroying our planet and undoing all the man-made achievements.

To reflect these considerations in practical decision making, we have to further adjust the definition and measurement of business goals. To be sensible, the firm must add a long-term perspective to its goals to include sustainable value maximization.

How Risk Managers Can Maximize Values

In this section we demonstrate how the concept of a firm maximizing its value can guide risk managers’ decisions. For simplicity’s sake, we provide an example. Assume that we base firm valuation on its forecasted future annual cash flow. Assume further that the annual cash flow stays roughly at the same level over time. We know that the annual cash flows are subject to fluctuations due to uncertainties and technological innovations, changing demand, and so forth.Capital budgeting is a major topic in financial management. The present value of a stream of projected income is compared to the initial outlay in order to make the decision whether to undertake the project. We discuss Net Present Value (NPV) in Chapter 4 "Evolving Risk Management: Fundamental Tools" for the decision to adopt safety belts. For more methods, the student is invited to examine financial management textbooks. In order to explain the inclusion of risk management in the process, we use the following income statement example:This example follows Doherty’s 1985 Corporate Risk Management.

We assume that the value of the firm is ten times the value of the profit,This assumes an interest rate for the cash flow of 10 percent. The value of the firm is the value of the perpetuity at 10 percent which yields a factor of ten. or $1,000 in this very simple example (10 × $100).This concept follows the net income (NI) approach, which was shown to have many drawbacks relative to the Net Operating Income (NOI) approach. See the famous Miller-Modigliani theorems in the financial literature of 1950 and 1960. Now, assume that the firm considers a new risk management policy in which $40 will be spent to improve safety (or insurance premiums). If all other factors are held constant, then the firm’s profits will decrease, and the firm’s value will also decrease. In other words, in the simplistic model of certainty, any additional expense would reduce the firm’s value and managers would, therefore, regard the situation as undesirable. It seems that in general, almost all risk management activities would be undesirable, since they reduce the hypothetical firm’s value. However, this analysis ignores some effects and, therefore, leads to incorrect conclusions. In reality, the risk manager takes an action that may improve the state of the firm in many directions. Recall our demonstration of the safety belts example that we introduced Chapter 4 "Evolving Risk Management: Fundamental Tools". Customers may increase their purchases from this firm, based on their desire to trade with a more secure company, as its chances of surviving sudden difficulties improve. Many also believe that, as the firm gains relief from its fears of risks, the company can improve long-term and continuous service. Employees would feel better working for a more secure company and could be willing to settle for lower salaries. In addition, bondholders (creditors) will profit from increased security measures and thus would demand lower interest rates on the loans they provide (this is the main effect of a high credit rating). Thus, risk management activity may affect a variety of parameters and change the expected profit (or cash flow) in a more complex way. We present the state of this hypothetical firm as follows:

The profit (or expected profit) of the company has risen. If the owners continue to demand a tenfold multiplication factor, then the firm’s value increases from $1,000 to $1,250. The increase is a direct result of the new risk management policy, despite the introduction of the additional risk management or insurance costs. Note that the firm’s value has increased because other stakeholders (besides the owners) have enjoyed a change of attitude toward the firm. The main stakeholders affected include the credit suppliers in the capital market, the labor market and the product customers’ market. This did not happen as a result of improving the security of the stockholders but as a result of other parties benefiting from the firm’s new policy.

In fact, the situation could be even more interesting, if, in addition, the owners would be interested in a more secure firm and would be willing to settle for a higher multiplier (which translates into lower rate of return to the owners).This happens if the corporate cost of capital decreases to about 9 percent from 10 percent. For example, if the new multiplier is eleven, the value of the firm would go up to $1,375 (125 × 11), relative to the original value of $1,000, which was based on a multiplier of ten.

This oversimplified example sheds a light on the practical complexity of measuring the risk manager’s performance, according to the modern approach. Top managers couldn’t evaluate the risk manager’s performance without taking into account all the interactions between all the parties involved. In reality, a precise analysis of this type is complicated, and risk managers would have a hard time estimating if their policies are the correct ones. Let us stress that this analysis is extremely difficult if we use only standard accounting tools, which are not sensitive enough to the possible interactions (e.g., standard accounting does not measure the fine changes that take place—such as the incremental effect of the new risk management policy on the sales, the salaries, or the creditors’ satisfaction). We described this innovative approach in hope that the student will understand the nature of the problem and perhaps develop accounting tools that will present them with practical value.

Risk managers may not always clearly define their goals, because the firm’s goals are not always clearly defined, especially for nonprofit organizations. Executives’ complex personal considerations, management coalitions, company procedures, past decisions, hopes, and expectations enter into the mix of parameters defining the firm’s goals. These types of considerations can encourage risk managers to take conservative action. For example, risk managers may buy too much insurance for risks that the firm could reasonably retain. This could result from holding the risk manager personally responsible for uninsured losses. Thus, it’s very important not to create a conflict between the risk managers’ interests and the firm’s interests. For example, the very people charged with monitoring mortgage issuance risk, the mortgage underwriters and mortgage bankers, had a financial incentive (commissions) to issue the loans regardless of the intrinsic risks. The resulting subprime mortgage crisis ensued because of the conflict of interest between mortgage underwriters and mortgage bankers. This situation created the starting point for the 2008–2009 financial crisis.

Risk managers must ascertain—before the damage occurs—that an arrangement will provide equilibrium between resources needed and existing resources. The idea is to secure continuity despite losses. As such, the risk manager’ job is to evaluate the firm’s ability or capacity to sustain (absorb) damages. This job requires in-depth knowledge of the firm’s financial resources, such as credit lines, assets, and insurance arrangements. With this information risk managers can compare alternative methods for handling the risks. We describe these alternative methods in the next section.

Nonfinancial Firm

First, we will work with a hypothetical, small, nonfinancial institution, such as a furniture manufacturer or high-tech hardware and software company. Table 5.3 "Hypothetical Retail and Wholesaler Fashion Apparel Balance Sheet—(Risks and ERM)" shows the hypothetical assets, liabilities, and equity of this business.

Based on Table 5.3 "Hypothetical Retail and Wholesaler Fashion Apparel Balance Sheet—(Risks and ERM)", we can list some areas for which enterprise risk managers (ERMs) need to involve themselves for risk mitigation. Note, these loss risks do not. As part of the executive team, enterprise risk managers regard all activities, including any involvement in opportunity risks that carry the potential of gains as discussed in Chapter 1 "The Nature of Risk: Losses and Opportunities".

Examples of ERM activities generated from the assets and the liabilities on the balance sheet are as follows:

• Building risk: The ERM or CRO has to keep all company buildings safe and operational. Most, if not all, companies carry insurance on all real property. We will discuss the reasons later in the text. However, this represents only part of the CRO’s activities. The risk management manual should give directions for how to take care of weather-related potential damages, or losses from fires or other perils. Furthermore, the risk manager should be involved in any discussions of how to convert some building parts into income–producing opportunities. This will entail carefully assessing potential cash flow streams from reliable and careful tenants, not only from their capacity to pay potential, but also from their capacity to keep losses at an absolute minimum. The CRO or ERM takes on the capital budgeting function and computes net present values with the appropriate risk factors, as shown in Chapter 4 "Evolving Risk Management: Fundamental Tools" with the example of the safety belts. They need to include some risk factors to measure tenant quality in terms of both paying the rent and maintaining the properties properly.
• Accounts Receivables and Notes Due: ERMs and CROs must create procedures to ensure that the accounts receivables can be collected and remain in good standing. This is key to sustainability—the ability to maintain expected cash flows. In addition, since the Fashion Apparel’s customers are from other countries, the decision of what currency to use is very important. As far as currency risk is concerned, the risk officer must negotiate with the suppliers and designers to set a mutually beneficial currency. This mutually beneficial currency will provide a very important means to pay the firm’s suppliers and global designers. The risk manager can use currency derivatives to hedge/mitigate the currency risk. Also, if the company uses credit to maintain inventory for the long term, the ERM procedures should include ways to handle interest rate risk on both sides. Such interest rate risk would affect both receivables and payments to vendors, designers, and suppliers. To ensure liquidity, many companies create interest-bearing credit lines from banks—as long as the interest rates are in line with what can be collected in the accounts receivable. The firm has to borrow money to create the cash flows to pay salaries and buy new inventory. At the same time, the firm receives interest from clients. These transactions create a need for interest-rate management while it is receiving interest from clients, there needs to be interest risk management, such as using swaps, which is explained in detail with an example in the next section of this chapter.
• If used correctly, the swap derivative can act as insurance to mitigate interest rate risk. The interest rate used for borrowing and lending must make sense in terms of the management of accounts receivable and notes due on the liabilities side of the balance sheet. See Figure 5.1 "The Links to ERM with Opportunities and Risks" showing the gains and losses that can occur because of interest rate and currency risks. They can also provide opportunities if handled with appropriate risk management. Note that the ability to obtain lines of credit from banks and suppliers and extend credit to customers is an integral part of the working of the cash flow of the firm. Indeed the credit crisis of 2008–2009 occurred in part because banks and other creditors lost confidence in the counterparty’s ability to pay, and the credit markets “froze.” This led to insolvencies, declines in stock value, and a general recession.
• Tools, furniture, and inventory: ERMs must take account of the traffic flow in the show room because they will want to establish sustainability and opportunities to make money. They must ensure that halls provide safety designs as well as fashion statements and innovative and creative designs to enhance visibility of the merchandise. Thus, while the risk manager is involved in avoiding or reducing losses, he/she is also involved in the opportunities. For example, it may be risky to hang some of the merchandise from the ceilings with wind tunnels that accentuate the flow of the fabrics, but it may also increase sales dramatically if the right effects are achieved. CROs must manage the opportunity risk (the chance to make money) with the appropriate risk factors as they compute the capital budget.
• Accounts Payable including the Mortgage on the Buildings → Capital Structure: Until the real estate crisis of 2008, real estate investments were stable. However, the CRO, working with other managers, must decide whether to purchase large assets with debt or equity from investors. The financing method is very important and it is regarded as the capital structureA firm’s choice between debt and equity. of the firm—the choice between debt and equity. In this company, the Apparel Designer, the building was purchased with a large mortgage (debt). The mortgage amount due is not subject to reduction unless paid. But, the buildings can decline in value, and at the same time the company’s net worth can be in jeopardy, with potentially catastrophic consequences. If our hypothetical example was a publicly traded company, it would have to show at the end of each year the true value of buildings—the market value. Under this scenario, with so much debt and so little owner’s equity, the balance sheet can show the firm as insolvent. The CRO or risk manager must address the company’s capital structure issue and point out the risks of taking large mortgages on buildings, since the properties may lose their value. The capital structure decision creates a need for managers to choose between financing property with debt versus equity. This tradeoff is a tricky one to negotiate. If the firm uses equity, it may be underinvested. If it uses debt, it runs the risk of insolvency. For example, we know that before the 2008 financial crisis, many firms used too much debt, leading to sustainability issues and liquidation, such as Circuit City.Circuit City announced its liquidation in the middle of January 2009 after they could not find a buyer to salvage the company that specialized in electronics.

Capital structure decisions as well as the nature of debt and its covenantsThe details of the contracts and promises between the debt contract parties. (the details of the contracts and promises between the debt contract parties), accounts receivables, and notes have been under the domain of the finance or treasury department of companies with a new breed of financial risk managersManagers responsible for managing the risk of the investments and assets of a firm.. These risk managers are responsible for managing the risk of the investments and assets of the firms using tools such as Value at Risk (VaR; discussed in Chapter 2 "Risk Measurement and Metrics") and capital markets instruments such as derivatives as explained in Chapter 2 "Risk Measurement and Metrics" and will be detailed in the next section of this chapter. Currently, the trend is to move financial risk management into the firm-wide enterprise risk management.

Financial Firm—An Insurer

Next, we move to the risk management function with regard to the balance sheet of financial institutions. We delve into an example of a hypothetical life insurance company. As you will see in the coming chapters, insurance companies are in two businesses: the insurance and investment businesses. The insurance side is the underwriting and reserving liabilities. UnderwritingThe process of evaluating risks, selecting which risks to accept, and identifying potential adverse selection. is the process of evaluating risks, selecting which risks to accept, and identifying potential adverse selection. Reserving liabilitiesCalculating the amount that the insurer needs to set aside to pay future claims. involves the calculation of the amount that the insurer needs to set aside to pay future claims. It’s equivalent to the debt of a nonfinancial firm. The investment side includes decisions about asset allocationThe mix of assets held by an insurer. to achieve the best rate of return on the assets entrusted to the insurer by the policyholders seeking the security. Asset allocation is the mix of assets held by an insurer; also, the allocation of assets is necessary to meet the timing of the claims obligations. This activity is called asset-liabilities matchingAllocation of an insurer’s assets to meet claims obligations as they become due.. The matching is, in essence, to ensure liquidityDegree to which assets can be used to meet a firm’s obligations (the more liquid an asset, the easier it can be used to meet obligations). so that when claims come due the firm has available cash to pay for losses.

When reviewing the asset portfolioDetails the assets that are to be matched to liabilities in the asset-liabilities matching process., also referred to as the investment portfolioDetails the assets that are to be matched to liabilities in the asset-liabilities matching process.. or asset allocationThe mix of assets held by an insurer. of an insurer, we see the characteristics of the assets needed to support the payment of claims of the specific insurer. Asset allocation is the mix of assets held by an insurer. A property or health insurer needs a quick movement of funds and cannot invest in many long-term investments. On the other hand, insurers that sell mostly life insurance or liability coverage know that the funds will remain for longer-term investment, as claims may not arrive until years into the future.

The firm maintains liability accountsReserves held on balance sheets to cover future claims and other obligations, such as taxes and premium reserves. in the form of reserves on balance sheets to cover future claims and other obligations such as taxes and premium reserves. The firm must maintain assets to cover the reserves and still leave the insurer with an adequate net worth in the form of capital and surplusThe equivalent of equity on the balance sheet of any firm—the net worth of the firm, or assets minus liabilities.. Capital and surplus represent equity on the balance sheet of a nonfinancial firm. We calculate the firm’s net worth by taking the asset minus liabilities. For students who have taken a basic accounting course, the balance sheet of a firm will be very familiar. Table 5.4 "Balance Sheet Structure of an Insurer" provides the two sides of the balance sheet of an insurer in insurance terminology.

The following is Table 5.5 "A Hypothetical Balance Sheet of a Hypothetical Life Insurance Firm with Its Asset Allocation Mix (in Millions of Dollars)—Risks and ERM", which shows the investment portfolio or the asset allocation of a hypothetical life insurer within its balance sheet. The asset mix reflects the industry’s asset distribution. Table 5.5 "A Hypothetical Balance Sheet of a Hypothetical Life Insurance Firm with Its Asset Allocation Mix (in Millions of Dollars)—Risks and ERM" also shows the liabilities side of that insurer.

The hypothetical life insurer in Table 5.5 "A Hypothetical Balance Sheet of a Hypothetical Life Insurance Firm with Its Asset Allocation Mix (in Millions of Dollars)—Risks and ERM" represents a typical insurer in the United States with a larger percentage of investment in bonds and mortgages and less investment in stocks. The ERM joins the executive team and regards all activities, including firm undertakings in opportunity and financial risks. Therefore, the risk manager works also as a financial risk manager on the side of the insurer’s asset allocation and capital structure questions. Examples of ERM activities generated from the assets and liabilities on the balance sheet are as follows:

• Risks from the liabilities: The liabilities comprise mostly reserves for claims on the products sold by the life insurer. The products here are life and annuities (this insurance company does not sell health insurance). Most of the reserves are for these products. The reserves are computed by actuariesIndividuals who specialize in forecasting the losses and developing the losses’ potential future impact on the insurers., who specialize in forecasting the losses and developing the losses’ potential future impact on the insurers. Actuaries use mortality tables and life expectancy tables to estimate the future losses that the insurer must pay. Mortality tablesTables that indicate the percent of expected deaths for each age group. indicate the percent of expected deaths for each age group. Life expectancyMeasure of the length of life expected for people born in each year. shows the length of life expected for people born in each year. Chapter 1 "The Nature of Risk: Losses and Opportunities" delves into this topic in detail. Usually, life insurance firms maintain a high level of expertise in selling products to people and categorizing them in similar risk levels. Insurance underwriters develop specialized expertise to ensure that the insurer does not sell the products too cheaply for the risks that the insurer accepts. As such, the enterprise risk manager depends on the actuarial and underwriting expertise to ensure the liabilities side of the business is well managed. If the reserve calculations miss the mark, the insurer can become insolvent very quickly and lose the capital and surplus, which is its net worth.Insurers have a special accounting system called statutory accounting. Only insurers that are publicly traded are required to show the market value of their assets in a separate accounting system, called GAAP accounting (Generally Accepted Accounting Procedures). The assets and liabilities shown in Table 5.5 "A Hypothetical Balance Sheet of a Hypothetical Life Insurance Firm with Its Asset Allocation Mix (in Millions of Dollars)—Risks and ERM" are based on the statutory accounting and the assets are booked at book value, rather than market value, except for the stocks. The differences between the two accounting systems are beyond the scope of this textbook. Nevertheless, the most important differences have to do with accrued liabilities and mark-to-market values of the assets. Statutory accounting does not require market values of bonds.
• Risks from the asset mix: The enterprise risk manager or CRO should ensure that the insurer’s investment portfolio or asset mix can perform and sustain its value. Our hypothetical life insurer posted $1,800 million in bonds. The mix of these bonds is critical, especially during the recent 2008–2009 global crisis (described in Chapter 1 "The Nature of Risk: Losses and Opportunities"). The amount of mortgage-backed securities (MBS) within the bonds is very critical, especially if these MBS are nonperforming and lose their value. As it turns out, the balance sheet we provided above represents a time before the credit crisis of 2008. This hypothetical insurer held 10 percent of its bonds in MBS and half of them turned into nonperforming assets by the end of 2008. This translates into $90 million of lost assets value in 2008. In addition, the stock market collapse took its toll and the 2008 market value of the stocks decreased by 30.33 percent. Investment professionals worked with a CRO to ensure a much lower decrease than the market indexes. They ensured that the stock portfolio was more conservative. If we assume that all other liabilities and assets did not suffer any additional loss, the capital and surplus of this hypothetical insurer will be almost wiped out at the end of 2008.This was reflected in the stock market with insurers such as Hartford Life, Genworth Life, and AIG life insurance, for example. This decline, without a decline in the liabilities, lowered the capital amount of these insurers.

As an insurer, the firm faces an outcome to the ERM function, since underwriting is a critical component for the insurer’s sustainability. Here, the balance sheet would show that the insurer invested in mortgage-backed securities (MBS), not doing its underwriting work itself. The insurers allowed the investment professionals to invest in financial instruments that did not underwrite the mortgage holders prudently. If the CRO was in charge completely, he would have known how to apply the expertise of the liabilities side into the expertise of the assets side and would have demanded clear due diligence into the nature of MBS. Warren Buffet, the owner of insurance companies, said he did not trust MBS and did not invest in such instruments in his successful and thriving businesses. Due diligenceThe process of examining every action and items in the financial statement of companies to ensure the data reflect true value. examines every action and items in the financial statement of companies to ensure the data reflect true value.