The author of Chapter 8 presents the concept of Key Risk Indicators and its value supporting risk management and strategic and operational performance. The third part of the book Chapters 9 to 13 is really interesting. It is full of practical examples and relevant tools. Chapter 9 discusses on how to create and use corporate risk tolerance. It presents a good discussion on the importance of a proper definition of corporate goals and the capacity to take risk. It is not usual to find this in risk management texts, not vital but could help.
Also presents the experience of Hydro One Networks Inc. The following chapter proposes a technique to allocate resources based on risk.
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Chapter 13 explains the world of quantification of non-financial risks. The author provides descriptions of four different approaches to the quantification of individual risks. The last one presents a Monte Carlo simulation but the discussion is quite light. I would be interested in more discussion on this. The fourth part, Chapter 14 to 21, is devoted to the different types of risks.
On my opinion, this is the second key part of the book. In the first chapter, the author talks about market risk and common elements with credit risk. The central idea is quite obvious but not less important: successful risk management strategies demand a clear understanding of underlying business beyond the usage of quantitative tools and techniques.
Chapter 15 starts by discussing the fundamental of credit default risk. Then present several credit mitigation techniques and closes discussing the credit crisis of Chapter 16 discusses operational risk. It is full of appropriate recommendations. The author, suggest two important ideas: the first one, not every single risk is negative and, the second; risk management should be more focused on value creation instead of value conservation. Chapter 17 proposes, a new perspective for risk management in order to avoid financial difficulties experienced in Basically, the author suggests going beyond the simple risk measures and build a risk management that integrates risk into strategic planning, capital management, and governance.
Chapter 18 explores the benefits of managing finance risk i. It finishes pointing out the interaction of financial risk with credit, operational, strategic and legal risk. A good review of the evolution of bank capital requirement is presented in Chapter Based on the deficiencies evidenced during the subprime crisis, the author says that the ERM and economic capital is the future of bank capital regulations. Chapter 20 and 21, are focused on legal and regulatory matters. Part V, Chapters 22 to 24, is devoted to topics not usually covered by risk management books.
In the same line, Chapter 23 provides a summary to date of research on this subject reaching similar conclusions. ERM needs to be part of the mind-set of every company stakeholder. When one arm of the company is pulling for its own gains without consideration of the total value it delivers to stakeholders, the result, no doubt, will be disastrous.
The players need to dance together under the paradigm that every action might have the potential to lead to catastrophic results. The risk of each action needs to be clear, and assuredness for risk mitigation is a must. While Chapter 4 "Evolving Risk Management: Fundamental Tools" enumerated all risks, we emphasized the loss part more acutely, since avoiding losses represents the essence of risk management. But, with the advent of ERM, the risks that represent opportunities for gain are clearly just as important.
We operate on the negative and positive sides of the ERM map and we look into opportunity risks. We introduce more sophisticated tools to ensure that you are equipped to work with all elements of risk management for firms to sustain themselves. Figure 5. Let us emphasize that, in light of the financial crisis of —, ERM is a needed mind-set for all disciplines. The tools are just what ERM-oriented managers can pull out of their tool kits.
For example, we provide an example for the life insurance industry as a key to understanding the links. We provide a more complete picture of ERM in Figure 5. Source: Etti G. Baranoff and Thomas W. As you saw in Chapter 4 "Evolving Risk Management: Fundamental Tools" , risk management functions represent an integrated function within the organization. In Figure 4.
While the enterprise risk management ERM function compiles the information, every function should identify risks and examine risk management tools. Finance departments may take the lead, but engineering, legal, product development, and asset management teams also have input. Even nonpublicly traded firms share the same goal. Instead of the simple stock value, nonpublic firms may well create value using inputs such as revenues, costs, or sources of financing debt of equity.
In and , even strong companies felt the effects from the credit crisis. Textron and other well-run companies saw their values plummet.
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The inputs for a model that determines value allow us to examine how each input functions in the context of all the other variables. See references to Capital versus Risks studies such as Etti G. Baranoff, Tom W. This approach replaces the traditional concept of profits maximization, or expected profit maximization, enabling us to introduce risky elements and statistical models into the decision-making process. Actual market value should reflect all these elements and includes all the information available to the market. This is the efficient-markets hypothesis.
Recently, many developed countries have seen a tendency to change the rules of corporate governance. Traditionally, many people believed that a firm should serve only its shareholders. However, most people now believe that firms must satisfy the needs of all the stakeholders—including employees and their families, the public at large, customers, creditors, the government, and others.
Enterprise Risk Management: Today’s leading research and best practices for tomorrow’s executives
In some countries, corporate laws have changed to include these goals. It reflects positive corporate responsibility image. 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. Fuel cost contributed in large part to the trouble that the U. With the U. 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. Chevrolet will offer a plug-in car called the Volt in the spring of with a range of more than 80 mpg on a single charge. Chrysler and Ford plan to follow with their own hybrids by World population growth and fast growth among emerging economies have led us to believer that our environment has suffered immense and irrevocable damage.
Its resources have been depleted; its atmosphere, land, and water quickly polluted; and its water, forests, and energy sources destroyed. From a risk management point of view, these risks can destroy our universe, so their management is essential to sustainability The 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.
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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. 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.
For more methods, the student is invited to examine financial management textbooks. Table 5. 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. See the famous Miller-Modigliani theorems in the financial literature of and 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. The increase is a direct result of the new risk management policy, despite the introduction of the additional risk management or insurance costs. 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. 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.
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. 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.
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 — 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. With this information risk managers can compare alternative methods for handling the risks. We describe these alternative methods in the next section. We show a balance sheet for a nonfinancial firm in Table 5. Firms must produce annual financial reports including their balance sheets and income statements.
Together, we call income statements and balance sheets financial statements Income statements and balance sheets. While we focused in the section above on a simplified hypothetical income statement, now we focus on the assets and liabilities as they appear at a certain point. With this ammunition at hand, we will be able to explain why financial institutions created so many problems during the — credit crisis.
First, we will work with a hypothetical, small, nonfinancial institution, such as a furniture manufacturer or high-tech hardware and software company. Based on Table 5. 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:. Capital structure decisions as well as the nature of debt and its covenants The details of the contracts and promises between the debt contract parties. 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.
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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. Underwriting The process of evaluating risks, selecting which risks to accept, and identifying potential adverse selection.
Reserving liabilities Calculating the amount that the insurer needs to set aside to pay future claims. The investment side includes decisions about asset allocation The mix of assets held by an insurer. 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. When reviewing the asset portfolio Details the assets that are to be matched to liabilities in the asset-liabilities matching process.
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 accounts Reserves held 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 surplus The 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. For students who have taken a basic accounting course, the balance sheet of a firm will be very familiar. The following is Table 5. The hypothetical life insurer in Table 5. The ERM joins the executive team and regards all activities, including firm undertakings in opportunity and financial risks.
Examples of ERM activities generated from the assets and liabilities on the balance sheet are as follows:. 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 diligence The process of examining every action and items in the financial statement of companies to ensure the data reflect true value. Enterprise risk management has emerged from the following steps of maturation:. The last two or three decades have been a period of rapid financial innovation. Capital markets soared and with the growth came the development of derivatives. Derivatives Financial securities whose value is derived from another underlying asset.
Derivatives are noninsurance instruments used to hedge, or protect, against adverse movements in prices in stocks or in commodities such as rice and wheat or rates such as interest rates or foreign exchange rates. As such, the firm is continually vulnerable to sudden increases in wheat prices. Using derivatives, we will explore the different choices in how an enterprise risk manager might mitigate the unwanted price exposure.
Forwards and futures are similar in that they are agreements that obligate the owner of the instrument to buy or sell an asset for a specified price at a specified time in the future. Forwards Financial securities traded in the over-the-counter market whose characteristics can be tailored to meet specific customer needs. Farmers and grain elevator operators also use forwards to lock in a price for their corn or soybeans or wheat. They may choose to lock in the basis The amount of money above and beyond the futures price.
Food and beverage companies use forwards to lock in their costs for grains and fruits and vegetables. Quaker Oats, for example, locks in the prices on corn and oats using forward contracts with growers. Anheuser Busch depends upon forwards to lock in the price of hops, rice, and other grains used to make beer. Dole fruit companies use forwards to price out pineapples, raspberries, grapes, and other fruits. Futures Financial securities that trade on an exchange and that have standardized contract specifications.
An example of a spot contract would be your agreement to purchase a meal at a restaurant. A futures or forwards market would be the price you would have to pay if you wanted the same meal one year from today.
Buying in the spot market creates exposure to later price fluctuation. On the other side, Continental Airline is suffering from buying aviation fuel futures when the price of oil subsequently declined dramatically. Thus, the use of futures and forwards can create value or losses, depending upon the timing of its implementation. Swaps Agreements to exchange or transfer expected future variable-price purchases of a commodity or foreign exchange contract for a fixed contractual price today. The net effect of the swap transaction is to receive the necessary wheat allotment each month while paying a fixed, predetermined rate.
The swap rate quote would be fixed using the spot market and the one-year forward market for wheat. Swaps are used in the same manner to exchange floating interest rate liabilities for fixed-interest rate liabilities. We will show an elaborate swaps example at the end of this section. Agreements that give the right but not the obligation to buy or sell an underlying asset at a specified price at a specified time in the future are known as options Agreements that give the right but not the obligation to buy or sell an underlying asset at a specified price at a specified time in the future.
The strike price also called exercise price is the specified price set in the option contract. Until the maturity date of the option passes, option holders can exercise their rights to buy wheat at the strike price. If the future price of wheat falls below the strike price, the company will not exercise its option and will instead purchase wheat directly in the spot market.
This differentiates the option contract from the futures contract. The option buyer pays the cost of the option to buy wheat at the strike price—also known as the option premium. A call option grants the right to buy at the strike price. A put option grants the right to sell at the strike price. A call option acts like insurance to provide an upper limit on the cost of a commodity. A put option acts like insurance to protect a floor selling price for wheat.
James T. Individuals and companies alike use derivative instruments to hedge against their exposure to unpredictable loss due to price fluctuations. The increasing availability of different derivative products has armed enterprise risk managers ERM with new risk management tool solutions.
An importer of raw materials can hedge against changes in the exchange rate of the U. An energy company can hedge using weather derivatives to protect against adverse or extreme weather conditions. And a bank can hedge its portfolio against interest rate risk. All of these risk exposures interrupt corporate cash flow and affect earnings, capital, and the bottom line, which is the value of the firm.
These solutions, however, create new risk exposures. Over-the-counter market-traded derivatives, which feature no exchange acting as counterparty to the trade, expose a company to credit risk in that the counter party to the contract may not live up to its side of the obligation. Dramatic changes have taken place in the insurance industry in the past two to three decades.
A succession of catastrophic losses has caused insurers and reinsurers to reevaluate their risk analyses. The reassessment effort was made in full realization that these disasters, as horrible as they were, may not be the last worst-case scenarios. Past fears of multiple noncorrelated catastrophic events occurring in a relatively short period of time are on the top of agendas of catastrophe risk modelers and all constituencies responsible for national disaster management.
Michael Himick et al. Packaging and transferring the insurance risks to the capital markets through the issuance of a financial security is termed securitization Packaging and transferring the insurance risks to the capital markets through the issuance of a financial security. The risks that have been underwritten are pooled together into a bundle, which is then considered an asset and the underwriter then sells its shares; hence, the risk is transferred from the insurers to the capital markets. Securitized catastrophe instruments can help a firm or an individual to diversify risk exposures when reinsurance is limited or not available.
Because global capital markets are so vast, they offer a promising means of funding protection for even the largest potential catastrophes.