What Is Enterprise Risk Management (ERM)?
Enterprise risk management (ERM) is a plan-based business strategy that aims to identify, assess, and prepare for any dangers, hazards, and other potentials for disaster—both physical and figurative—that may interfere with an organization's operations and objectives.
The discipline not only calls for corporations to identify all the risks they face and to decide which risks to manage actively, but it also involves making that plan of action available to all stakeholders, shareholders and potential investors, as part of their annual reports. Industries as varied as aviation, construction, public health, international development, energy, finance, and insurance all utilize ERM.
Companies have been managing risk for years. Historically, they've done this by buying insurance: property insurance for literal, detrimental losses due to fires, thefts and natural disasters; and liability insurance and malpractice insurance to deal with lawsuits and claims of damage, loss, or injury. But another key element in ERM is a business risk—that is, obstacles associated with technology (particularly technological failures), company supply chains, and expansion—and the costs and financing of same.
More recently, companies have managed such risks through the capital markets with derivative instruments that help them manage the ups and downs of moment-to-moment movements in currencies, interest rates, commodity prices, and equities. From a mathematical point of view, all of these risks or "exposures" have been reasonably easy to measure, with resulting profits and losses going straight to the bottom line.
Understanding Enterprise Risk Management
Modern businesses, however, face a much more diverse collection of obstacles and potential dangers. How companies manage the risks that defy easy measurements or a framework for management also falls under the ERM umbrella. These potentials for exposure include crucial risks such as reputation, day-to-day operational procedures, legal and human resources management, financial, and other controls related to the Sarbanes-Oxley Act of 2002 (SOX), and overall governance.
Project managers and other professionals who work with ERM focus on assessing the risks relevant to their companies or industries, prioritizing those risks, and making informed decisions on how to handle them. The risk management plans they create estimate the impact of various disasters and outline possible responses if one of these disasters materializes. For example, the Environmental Protection Agency (EPA) requires facilities that deal with extremely hazardous substances to develop risk management plans to address what they are doing to mitigate danger and what they will do if an accident occurs.
In addition to just-in-case plans and products, such as a list of alternate suppliers or an insurance policy, companies that successfully manage their risks also adopt routine practices to manage the potential hazards they have identified. In many cases, new positions are created, such as enterprise risk managers, or new departments are developed to integrate risk management into everyday operations, including equipment maintenance and quality control or assurance teams.
Advantages of ERM
In putting together ERM initiatives, companies should focus not only on the downside of risk but the upside as well. The traditional approach was to concentrate on negatives—the losses from currency or interest rate trades in financial markets, for instance, or financial losses that might be caused by a disruption in a supply chain or a cyber attack that impairs a company's information technology.
In thinking about the upside, companies now are supposed to consider competitive opportunities and strategic advantages that might arise out of deft management of risk. Some of these "better decisions" involve items like where to locate a plant or office abroad based on a risk analysis that would examine the political environment in a country.
The "upside" also includes focusing on preventive measures that help a company avoid potential disasters down the road. For example, some of these actions may include determining when and how physical assets need to be maintained and replaced.
This way, the company can avoid unexpected and costly plant and equipment failure that might result in shutdowns, explosions or other events that put a company's employees, communities, and public profile at risk. Understanding that their most important and valuable asset is their image, some companies work proactively when dealing with man-made or natural disasters.
- The enterprise risk management business strategy identifies and prepares for hazards with a company's operations and objectives.
- ERM is a new and evolving management discipline.
- What constitutes "best practices" in ERM has yet to be defined.
- ERM-friendly companies can be found by searching dedicated ERM websites.
ERM and Investing
Studying how corporations manage the incredibly diverse number of risks they face can play an extremely important role in investment decision-making. Knowledge of individual corporate "risk profiles" can lead investors to identify up-and-coming companies, investing with the confidence that they could meet corporate objectives and investor expectations (not only in good times but also in bad).
It can also help to better understand which companies to allow into your community through a new plant or office, believing that they would do everything possible to avoid environmental damage and to treat employees well.
Until now, particularly in the U.S., the vast majority of corporations have made very little information about their overall risk profiles available to stakeholders. Companies in many other industrialized countries, like Canada, the U.K., and Australia, are much more forthcoming about risk and ERM activities.
However, the situation's poised to change as the rating agencies start to factor in a company's ability to manage ERM. Stakeholders will start to see a plethora of new risk-related data and information available to them. This story of risk management is likely to expand greatly over the next decade.
Finding ERM-Friendly Companies
It is a difficult task for investors to discover which companies are working to manage risk from an enterprise-wide perspective—and an even more difficult job discovering who is doing so effectively. Many corporate board members don't understand ERM, believing it to be simply another potentially costly, hard-to-measure regulatory fiat from Washington.
Many others believe that effective ERM can be achieved simply by expanding their SOX-related reporting and controls efforts, which is not the case.
Because it's a new management discipline, ERM's "best practices" are still evolving.
Currently, it's being delineated industry by industry, but few if any companies promote themselves as being "best of the best" in ERM or risk management. So how do you know who are working hard at effective ERM? One way is to check the executive roster for a chief risk officer (CRO).
While CROs are most often found in the energy, banking and insurance industries, more aggressive manufacturing companies are moving in that direction as well. Another clue is found in a tiny nut of companies that have managers specifically in charge of coordinating their ERM efforts. These managers will have the words "enterprise risk" in their titles. Intensive additional sleuthing from investors may offer worthwhile dividends.
Simply searching "enterprise risk management" online will give investors access to numerous recent conference agendas on the topic. Investors should then take note of which companies have executives lecturing on ERM. Also check out the websites of the few associations dedicated to promoting ERM, such as the Risk & Insurance Management Society in New York or the Committee of Chief Risk Officers.
The Conference Board in New York also has a dedicated practice examining corporations and their ERM endeavors, and the National Association of Corporate Directors has done a somewhat dated but invaluable Blue Ribbon report on how corporate board members think about risk—and how that needs to change.
As a word of caution, just because a company has a CRO—or brags about what it's doing in ERM—doesn't mean you should take it at its word. You'll need to look deeper and ask investor relations executives detailed questions.
For years, the banking industry has boasted of having the best risk management and ERM programs of any industry. None of that, however, prevented the 2007 credit crunch and mortgage meltdown.
Example of Enterprise Risk Management
One of the most model reputation risk management stories in corporate history involves Johnson & Johnson. The pharmaceutical giant found its reputation and its stock price severely bruised in 1982 over revelations that someone had tampered with and poisoned bottles of its pain reliever Tylenol, resulting in several deaths.
The company reacted quickly, removing and replacing its products at retail outlets, cooperating fully with law enforcement authorities, and keeping the media (and, hence, the public) informed throughout. Its decisive actions and honest open communication during the crisis helped in the recovery of share value within a few months.
From 2006 to 2008, the recent push for companies is to prove they are "going green," hoping that aggressive environmental risk management will position their products, plants, supply chain, and other operations positively with current and future customers.