Irisk nianaiieinpiit

F r o m C o m p l i a n c e T o V a l u eA unifying framework can help companies identify and articulate risks consistently across

the enterprise and evaluate alternative capital structures to bear those risks.

By Prakash Shimpi

B usinesses take risks every dayto create value for their share-holders. Managing those riskshas always been an importantelement of running any enterprise,although the link to value creation hasnot always been clear. But growingdemands from shareholders for seniormanagement to take enterprise riskmanagement (ERM) more seriouslyhas at last formalized the essentialconnection between a company'sbusiness operations and its overallrisk management program.

Until now, these functions haveoperated as silos within many organi-zations. For non-financial companies,in particular, the latest wave of corpo-rate scandals and breakdowns in cor-porate controls has been a catalyst forrevolutionary changes.

Inevitably, the initial stages of ERMhave been mostly about complianceand corporate go\ernance. New rulesand responsibilities have beenimposed on senior management andboards, which ha\ e resulted in highercosts, resource constraints and many

questions about whether these newregulations are really the answer. Butwe are now entering a new era, whereleading companies wish to harnessERM as a strategic tool that will helpthem increase shareholder value.

What follows describes a unifyingframework that can be used to articu-late risks consistently across an organ-ization and evaluate alternative capitalstructures — comprising equity, debt,insurance and hedging — to bearthose risks. Ultimately, ERM is aboutcommunication. Senior managementmust have well-de\eloped, currentinformation and credible insights tocommunicate the basis for its actionsin both good times and bad.

Evolution of ERMThis framework is, in effect, the nextstep in the evolution of attempts toquantify and manage risk. And muchof that effort has taken place in thefinancial services sector, among banksand insurers. While we often thinktoday of banks as the leading riskmanagers in financial services, in fact.

the evolution of ERM techniquesowes a great deal to the insuranceindustry.

In the 1950s, the actuarial profes-sion developed a formal asset/liabili-ty management (ALM) method forassessing and managing the interestrate risk embedded in the long-termproducts of life insurers. This method,known as "immunization," has sincebecome the foundation of several riskmanagement techniques in life insur-ance, pensions, banking and deriva-tives. The volatile interest rate envi-ronment of the late 1980s led to thedevelopment of more sophisticatedALM analysis, including the simula-tion of a wider set of risks and theirfinancial impact over a variety of sce-narios and time horizons.

Much of what we know aboutmanaging "event" risks, often with thechallenge of sparse data, has comefrom the property/casualty (PC)insurers, where the principal ques-tions about an event are "if" and "howbig." PC insurers have developedincreasingly sophisticated tools to

52 FINANCIAL EXECUTIVE July/August 2005

manage their portfolio of risks andassess the capital they need to runtheir businesses. The most notable toolis dynamic financial analysis (DFA),which has the same underlying princi-ples of ALM but addresses a widerrange of risks to the business entit)'.

Banks, like insurers, have devel-oped sophisticated risk managementtechniques to assess whether theyhave sufficient capital — spurred inpart by the growth in the derivativesmarkets in the last 20 years. For themost part, these risks are activelytraded, with a wealth of data avail-able to validate and calibrate pricingand hedging models.

More recently, all enterprises havebeen challenged to find a robust wayto qualify, quantify and manage oper-ational risks. The highly publicizedfailures of companies in North Ameri-ca, Europe and Asia indicate thatlapses in good management can hap-pen anywhere and in any industry.These failures have led to new sets ofregulations across the globe, intendedto increase transparency, accountabili-ty and good corporate governance.

The effect has been to formalizerisk management with a more com-prehensive scope. ERM embracesboth the compliance and governanceenvironment of a company, as well asthe financial management of theenterprise risks.

Now, leading companies are doing

more than complying with new cor-porate governance regulations. Theyare using ERM to create value.

From Compliance to ValueThe value of ERM is the ability tooptimize the value created from thejoint management of risk and capital.That is easier said than done. Whilethe relationship between risk and cap-ital management seems clear enoughin principle, the question is, how doesa company put that principle intoaction?

To do so, management needs a uni-fying framework that is valid for thefinancial management of the fullrange of risks that it faces and that canbe used at the tactical (product line) orstrategic (senior executive) levels. Thiscan be achieved if the risk capitalmanagement (RCM) framework:

1. combines actuarial techniqueswith the capital markets perspectivesof corporate finance; and

2. explicitly recognizes that riskfinancing instruments such as insur-ance and derivatives act as equitysubstitutes.

The actuarial perspective beginswith a bottom-up evaluation of eachindividual risk explicitly and thenaggregates that information into anoverall assessment of the portfolio ofrisks. This analysis leads to a determi-nation of the amount of capital need-ed to support the portfolio of risks.

The corporate finance perspectivefocuses on the company's capital struc-ture. Its purpose is to increase share-holder value by delivering the optimalbalance sheet composed of equity anddebt that minimizes the cost of capital,not just in absolute terms, but relativeto the price of risks it bears.

Both actuaries and corporatefinance managers know intuitivelythat "risk" and "capital" are related.Their joint perspective leads natu-rally to the question of how insur-ance and hedging instrumentsshould be treated in the analysis ofrisk financing alternatives. There areessentially two choices that can bemade: either treat them as offsets torisk, or treat them as capital.

Conventionally, capital is definedas only those instruments that provideimmediate cash to the company (suchas equity and debt) and exclude con-tingent capital (such as insurance andderivatives) that may bring cash to thecompany at some later date. The totalpaid-up capital (debt plus equity)must be sufficient to bear the net riskof the company after insurance andhedging. The capital structure deci-sion is about financial leverage, whichselects the mix of equity and debt.

Alternatively, the definition of cap-ital can be broadened to include allinstruments that reduce the need forequity. With this definition, the sum ofthe paid-up and contingent capital

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must be sufficient to bear thegross risk of the company. Thecapital structure decision com-bines financial leverage (equityvs. debt) and risk leverage (riskretention vs. risk transfer) tofind the best mix of equity, debtand insurance.

Strategic RCV FrameworkA strategic risk capital value(RCV) framework (Figure 1)connects value creation to thefundamental choices that man-agers make on a daily basis. Essential-ly, the portfolio of enterprise risks andthe portfolio of capital resources arethe two major items that managementcan change to advance the company'sinterests.

Conventionally, risk managementand capital management have operat-ed as two different disciplines and,indeed, as two (or more) separateoperations within a company. Never-theless, the two have always had aclose economic relationship. In a cor-porate setting, this relationship actslike a "force of gravity," keeping thetwo portfolios of enterprise risk andcapital resources tightly connected;the amount of risk dictates the capitalneeded and, vice versa, the amount ofcapital determines the risk capacity.

The relationship between risk andcapital is not always easy to articu-late. In this framework, this relation-ship is developed by referring to anintermediate measure, economic capi-tal (EC). In its purest sense, economiccapital is the true measure of the"weight" of a company's risks. (Thisterm distinguishes EC from othermeasures that are also important forthe company, such as rating agencycapital or generally accepted account-ing principles, or GAAP, capital.)

The company's risk structure (thefinancial impact of the company's riskexposures as they unfold over time

A Strategic Risk-Capital-Vatue Framework

Maximize value byrelating a firm'sdecisions on the risks ittakes to Itie decisionson the capital it uses tofinance its business

and scenarios) is measured by EC. Inpractice, this is done by running adynamic EC model that simulates thecompany's financials over a range ofpossible futures and produces theminimum amount of capital that thecompany needs to bear its risks.

With EC setting the minimumamount of capital needed, the key cor-porate finance question is: What is thebest capital structure for the compa-ny? The same dynamic EC model canhelp managers evaluate differentcombinations of capital resources(such as equity, preferred, debt, insur-ance or hedging).

The ultimate aim is to create value.The company is expected to generatereturns on the risks inherent in itsactivities. Holding capital — both incash form, as well as in contingentform — results in a cost reflecting theprice of accessing that capital.Through its selection of risks and capi-tal, management has the opportunityto maximize value creation (shown inthe top half of the diagram), bearing inmind the constraints imposed by riskand capital management (shown inthe bottom half of the diagram). Inshort, value is created when the returnon risk exceeds the cost of capital.

Putting It into PracticeAlthough the use of ERM in the finan-cial services sector mav be more famil-

iar, non-financial corporationsare also able to use ERM strate-gically to create value. Here aretwo examples:

• A major industrial firmhas credit exposure to its sup-pliers and buyers. It has alwaysmanaged the individual expo-sures, but now assesses theportfolio effect of this risk,together with other significantrisks. It is able to describe thestructure of the credit risk —how it looks under different

economic scenarios — and use thatinformation to improve contractingterms and product pricing.

• A growing manufacturingcompany needs to finance capitalinvestments to upgrade its physicalplant. Its cost of financing reflectsrisks to supply and demand and theconsequent volatility of earnings.The firm uses ERM analysis todevelop the mix of new capital —debt and insurance — that enablesit to execute its plan with the great-est economic value.

Ultimately, all companies are inthe business of risk and capitalmanagement. Many havealready made significant

investments in assessing their risks.Now, managers have the opportunityto take the next step, utilizing a unify-ing framework, to include more ofthese risks in their planning to devel-op a more comprehensive analysis oftheir strategic options. While regulato-ry actions may have provided the ini-tial impetus, the insights gained fromthis analysis can profoundly affectmanagement's ability to create value.

Prakash Shimpi is a consultant at the

Tillinghast business of Towers Perrin with

global responsibility for leading the firm's

ERM practice. He can be reached at

praka5hshimpi@t0wersperrin.com.

ERM has at last formalized the essential connectionbetween a company's business operations and its overallrisk management program.

I We are in a new era, where risk management is more thancompliance, and leading companies will harness ERM as astrategic tool to help them boost shareholder value.

• A unifying framework is valid for the financial manage-ment of the full range of risks that a company faces andthat can be used at the tactical or strategic levels.

IA dynamic economic capital model can help managersevaluate combinations of capital resources (equity,preferred, debt, insurance or hedging) to build value.

July/August 2005 www.fei.org 55