Evaluating the upside of risk management

'Risk' is too often viewed with a strictly negative connotation, and as a result 'risk management' is viewed narrowly as measures taken to reduce risk. Whether it is mitigating the impact of an unplanned event, avoiding penalties from non-compliance or preventing hikes in insurance costs, risk management has tended to be viewed as an expense, rather than as an enabler.

More and more companies now recognise, however, that risk can create valuable upside in their business, when managed effectively. The better a company can understand how risk impacts its key performance indicators – both positively and negatively – and the more that it can embed the management of risk into day-to-day activities, the easier it will be to define the value that risk management brings, in concrete terms.

These were some of the key themes discussed at the 2007 European Risk Management Conference, in the workshop run by Marsh. The three principal areas under discussion, within the overall theme of value from risk management, were financial, business strategy and risk transfer.

Financial upside

All companies have markets in which they choose to operate, strategies that they believe will deliver the goals that they set in those markets, and financial models, metrics and ratios against which performance will be measured. Risk effectively represents the potential volatility around these key metrics. Volatility is not necessarily a bad thing, if it means that a company can gain an advantage by responding more effectively to it than the competition. But volatility needs to be anticipated, measured and managed if it is to be leveraged. This is the essence of risk management.

Risk management can help to mitigate earnings volatility and put into place measures to improve underlying corporate performance. Intuitively, a reduction in earnings volatility may have a positive impact on credit rating. Similarly, a more steady and predictable income stream may lead to the application of a lower discount on future cash flows by analysts. Both of these factors could lead to a higher valuation over time. The exception might be where investors manage volatility within a balanced portfolio.

A client of Marsh in the electronics manufacturing sector identified a heavy dependence on a complex supply chain which would take six months to fully restore following a business interruption. Marsh developed a sophisticated supply chain and business continuity solution for the client, and in doing so reduced its business interruption exposure by £40m. By mitigating this potential earnings volatility, it enabled the company to reinvest subsequent insurance savings in business enabling activities.

Strategy upside

Organisations make scores of decisions that determine where they invest, what their operating model looks like and how they grow their business. With the right decisions, the company can realise revenue growth, or reduce costs. But limited or inaccurate information, or a disregard of key uncertainties and risks, can lead to ineffective decision making and have a negative impact on cash flow, profitability and success. The application of risk assessment and modelling techniques to major business decisions ensures rigor, consistency and the most appropriate use of capital.

A chemical company, a client of Marsh, was expanding and needed to source a new factory to relieve production pressures. A number of options were available at several locations. With the support of Marsh, the company built a weighted decision-making model enabling it to better understand the implications and risks at each site, and to validate its decision.

Where companies have genuinely embedded risk into their decision-making processes, some have chosen to disclose this level of sophistication of approach within their annual report and accounts: such disclosure contributes to investor confidence over governance within the business.

Risk transfer upside

Insurance may seem to some companies to be a written-off commodity spend, incapable of delivering value beyond financial protection. But risk transfer can often represent a significant economic commitment for companies. Those that continue to view it as simply an annualised insurance procurement are probably missing an opportunity to extract better value from capital in their business.

Companies that seek to optimise their spend on risk transfer in light of their strategic direction, risk appetite, expected losses and quality of risk management, very often discover that they can make significant savings on their total cost of risk, which can be redeployed in a way that creates value. In some cases they find that their balance sheet can comfortably absorb more losses than the current insurance programme allows. On other occasions, they find that a risk can be considerably mitigated before it is financed.

The fact that some companies still fail to fully understand the opportunity that risk presents, means that risk management often plays a limited role in the boardroom. Risk is seen as something to be avoided rather than capitalised on, and the role of the risk manager falls short of its potential. We believe this situation is changing: leading companies are increasingly seeing the tangible value that can be brought from more efficient decision-making and reduced earnings volatility, and are consciously placing risk management at the heart of their strategic agenda.

James Maxwell is senior vice president of Marsh’s risk consulting practice