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ERM Helps Companies Strike the Right Risk/Reward Balance

Enterprise risk management (ERM) has been talked about for years, but hasn’t received a lot of attention outside the financial service sector. However, it now appears to be more than a passing fad. Last year, Standard & Poor’s announced it would incorporate an ERM review into its rating process for non-financial companies to “enhance transparency by providing investors and issuers our views of a management team’s ability to understand, articulate and successfully manage risk.”

This critical tool can help you identify your risks, reconcile them with corporate objectives, make informed capital deployment decisions and, ultimately, enhance shareholder value.

Taking an integrated approach

Although plenty of companies have implemented ERM systems, the concept remains widely misunderstood. Many people mistakenly believe that ERM simply means applying risk management techniques throughout the enterprise. However, addressing risk management in each department or division isn’t enough. True ERM means analyzing cross-enterprise risks and developing an integrated response to them.

Traditionally, companies have managed risk in isolated “silos.” The credit department, for example, focuses on credit risk, the legal department on regulatory and compliance risk and the procurement department on supply chain risk. Within each department, risk managers work to eliminate or minimize risk. There are two significant problems with this approach:

1. It incorrectly assumes that the goal of risk management is to avoid risk; and
2. It ignores the fact that risks are often interrelated.

Driving shareholder value

The traditional silo approach to risk management often assumes that risk is a bad thing, when, in fact, risk is the very factor that drives shareholder value. Without risk, there would be no reward.

Investors value your company by weighing risk against the potential reward. If they decide the amount of risk is appropriate (i.e., the anticipated reward justifies the risk), your company’s value increases. If the risk is too high or the rewards too low, your company’s value decreases.

The goal of ERM, therefore, is not to reduce risk, but to optimize it. It evaluates risk relative to your company’s risk tolerance, recognizing that not only can risk be too high, but it can also be too low.

Consider credit risk. Given today’s turbulent markets and uncertain economy, it’s easy to see how your credit department might become preoccupied with minimizing credit risk. If your credit policies become too tight, you might inadvertently turn away lucrative business and therefore harm profitability.

Risks are interrelated

The silo approach also often underestimates the extent to which various risks are connected. An action taken in one area might reduce risk in that area while it increases risk in another.

Suppose, for example, that the manager of a manufacturer’s purchasing department is concerned about shortages of certain plastics used in its products. Even a relatively small increase in the price of raw materials would take a big bite out of the company’s profits.

To reduce this risk, the manager begins purchasing substitute materials that are similar in quality and plentiful in supply. But he fails to realize that, unlike the old materials, the new materials contain substances that are harmful to the environment. When word of this gets out, the company’s sales plummet.

Had the company been using ERM, the purchasing manager might have considered not only the supply chain risk, but also the reputation risk involved in switching to less environmentally friendly materials. Armed with that information, he could have explored less-costly alternatives. For example, the company could have negotiated long-term supply contracts to lock in current materials prices. That would have reduced its supply chain risk without affecting its reputation risk.

Adopting ERM

In today’s global marketplace, companies are exposed to a wider range of risks than ever before—from market and credit risk to terrorism and political risk. ERM can help you evaluate and manage risk on a company-wide basis, taking into account issues you might otherwise overlook. Unfortunately, there isn’t one right way to implement ERM, which may explain why, despite its obvious benefits, many companies have been slow to adopt it.

The manner in which a company should implement ERM depends on many factors including its industry, size, risk profile and resources. Regardless of the particular implementation approach you decide to use, the key to success is to have processes in place for:

• Gathering risk information throughout your enterprise 
• Identifying key risks
• Analyzing the impact of alternative risk mitigation strategies on an enterprise-wide basis 
• Executing the most effective strategies

Several technology tools have been developed that strive to automate the ERM process. These systems gather relevant data, alert business managers to emerging risks and guide them in developing appropriate responses using sophisticated modeling techniques and “what if” scenarios.

One good place to begin the implementation process (though by no means the only one), is to review the ERM “Integrated Framework” developed by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). This framework discusses key ERM principles and concepts and provides guidance on the essential components of an ERM system. (See “The COSO Framework” on page 2.)

Keeping a big-picture focus Companies that survive and thrive in the coming years will be the ones that do the best job of managing risk. ERM is a powerful tool that can enable your company to get a more accurate picture of the risks it faces and to develop an integrated, effective response to risk. 

Questions on ERM? Contact Brian Langham at 312-980-2990.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.