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5.1 Enterprise Risk Management within Firm Goals
- In this section you will learn how the ERM function integrates well into the firm’s main theoretical and actual goal: to maximize value. We show a hypothetical example of ERM adding value to a firm.
- We also discuss the ambiguities regarding the firm goals.
As you saw in Chapter 4 "Evolving Risk Management: Fundamental Tools", risk management functions represent an integrated function within the organization. In Figure 4.2 "Notable Notions Risk Map", we map every risk. 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. The individual concerned with the organization’s ERM strategy is often given the position chief risk officer (CRO)Part of the executive team responsible for all risk elements in the organization.. The CRO is usually part of the corporation’s executive team and is responsible for all risk elements—pure and opportunity risks.
In this section, we illustrate in simple terms how the function integrates well into the firm’s goal to maximize value. In terms of publicly traded corporations, maximizing value translates to maximizing the company’s stock value. Even nonpublicly traded firms share the same goal. With nonpublicly traded firms, the market isn’t available to explicitly recognize the company’s true value. Therefore, people may interpret the term “firm’s value” differently with public versus nonpublic companies. 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). While “cash-rich” companies have greater value, they may not optimally use their money to invest in growth and future income. External variables, such as the 2008–2009 credit crisis, may well affect firm value, as can the weather, investors’ attitudes, and the like. In 2008 and 2009, even strong companies felt the effects from the credit crisis. Textron and other well-run companies saw their values plummet.
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 and Thomas W. Sager, “The Impact of Mortgage-backed Securities on Capital Requirements of Life Insurers in the Financial Crisis of 2007–2008,” Geneva Papers on Risk and Insurance Issues and Practice, The International Association for the Study of Insurance Economics 1018–5895/08, http://www.palgrave-journals.com/gpp; Etti G. Baranoff, Tom W. Sager, and Savas Papadopoulos, “Capital and Risk Revisited: A Structural Equation Model Approach for Life Insurers,” Journal of Risk and Insurance, 74, no. 3 (2007): 653–81; Etti G. Baranoff and Thomas W. Sager, “The Interrelationship among Organizational and Distribution Forms and Capital and Asset Risk Structures in the Life Insurance Industry,” Journal of Risk and Insurance 70, no. 3 (2003): 375; Etti G. Baranoff and Thomas W. Sager, “The Relationship between Asset Risk, Product Risk, and Capital in the Life Insurance Industry,” Journal of Banking and Finance 26, no. 6 (2002): 1181–97. Once we get an appropriate model, we can determine firms’ values and use these values to reach rational decisions. Traditionally, the drive for the firm to maximize value referred to the drive to maximize stockholders’ wealthValue of equity held by the owners of a company plus income in the form of dividends.. In other words, the literature referred to the maximization of the value of the firm’s shares (its market valueFor a public firm, the price of the stock times the number of shares traded., or the price of the stock times the number of shares traded, for a publicly traded firm). 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. We just have to decipher the particular model by which we wish to calculate the firm’s value and to enumerate the many factors (including risk variables from the enterprise risk map) that may affect firm value. 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. A company is a “good citizen” if it contributes to improving its communities and the environment. In some countries, corporate laws have changed to include these goals. This newer definition of corporate goals and values translates into a modified valuation formula/model that shows the firm responding to stakeholders’ needs as well as shareholder profits. These newly considered values are the hidden “good will” values that are necessary in a company’s risk management. We assume that a firm’s market value reflects the combined impact of all parameters and the considerations of all other stakeholders (employees, customers, creditors, etc.) A firm’s brand equityThe value created by a company with a good reputation and good products. entails the value created by a company with a good reputation and good products. You may also hear the term a company’s “franchise value,” which is an alternative term for the same thing. It reflects positive corporate responsibility image.
Maximization of Firm’s Value for Sustainability
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. In the summer of 2008, the cost of gas rising to over $150 a barrel and consumers paying more than $4 at the pump for a gallon of gas, alternatives have emerged globally. At the time of writing this textbook, the cost of gas had dropped significantly to as low as $1.50 per gallon at the pump, but the memory of the high prices, along with the major financial crisis, is a major incentive to production of alternative energy sources such as wind and sun. Fuel cost contributed in large part to the trouble that the U.S. automakers faced in December because they had continued to produce large gas-guzzlers such as sport-utility vehicles (SUVs) with minimal production of alternative gas-efficient cars like the Toyota Prius and Yaris, the Ford Fusion hybrid, and the Chevrolet Avio. With the U.S. government bailout of the U.S. automobile industry in December 2008 came a string of demands to modernize and to innovate with electric cars. 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).See references to Capital versus Risks studies such as Etti G. Baranoff and Thomas W. Sager, “The Impact of Mortgage-backed Securities on Capital Requirements of Life Insurers in the Financial Crisis of 2007–2008,” Geneva Papers on Risk and Insurance Issues and Practice, The International Association for the Study of Insurance Economics 1018–5895/08, http://www.palgrave-journals.com/gpp; Etti G. Baranoff, Tom W. Sager, and Savas Papadopoulos, “Capital and Risk Revisited: A Structural Equation Model Approach for Life Insurers,” Journal of Risk and Insurance, 74, no. 3 (2007): 653–81; Etti G. Baranoff and Thomas W. Sager, “The Interrelationship among Organizational and Distribution Forms and Capital and Asset Risk Structures in the Life Insurance Industry,” Journal of Risk and Insurance 70, no. 3 (2003): 375; Etti G. Baranoff and Thomas W. Sager, “The Relationship between Asset Risk, Product Risk, and Capital in the Life Insurance Industry,” Journal of Banking and Finance 26, no. 6 (2002): 1181–97. Chevrolet will offer a plug-in car called the Volt in the spring of 2010 with a range of more than 80 mpg on a single charge. Chrysler and Ford plan to follow with their own hybrids by 2012.
World population growth and fast growth among emerging economies have led us to believer that our environment has suffered immense and irrevocable damage.See environmental issues at http://environment.about.com/b/2009/01/20/obama-launches-new-white-house-web-site-environment-near-the-top-of-his-agenda .htm, http://environment.about.com/b/2009/01/12/billions-of-people-face-food-shortages-due-to-global-warming.htm, or http://environment.about.com/b/2009/01/20/obamas-first-100-days-an-environmental-agenda-for-obamas-first-100-days.htm. Its resources have been depleted; its atmosphere, land, and water quickly polluted; and its water, forests, and energy sources destroyed. The 2005 United Nations Millennium Ecosystem report from 2005 provides a glimpse into our ecosystem’s fast destruction. From a risk management point of view, these risks can destroy our universe, so their management is essential to sustainabilityThe 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.http://en.wikipedia.org/wiki/Sustainability. 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.
How Risk Managers Can Maximize Values
In this section we demonstrate how the concept of a firm maximizing its value can guide risk managers’ decisions. For simplicity’s sake, we provide an example. 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. We discuss Net Present Value (NPV) in Chapter 4 "Evolving Risk Management: Fundamental Tools" for the decision to adopt safety belts. For more methods, the student is invited to examine financial management textbooks. In order to explain the inclusion of risk management in the process, we use the following income statement example:This example follows Doherty’s 1985 Corporate Risk Management.
Table 5.1 Example of an Income Statement Before Risk Management
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. or $1,000 in this very simple example (10 × $100).This concept follows the net income (NI) approach, which was shown to have many drawbacks relative to the Net Operating Income (NOI) approach. See the famous Miller-Modigliani theorems in the financial literature of 1950 and 1960. Now, assume that the firm considers a new risk management policy in which $40 will be spent to improve safety (or insurance premiums). If all other factors are held constant, then the firm’s profits will decrease, and the firm’s value will also decrease. In other words, in the simplistic model of certainty, any additional expense would reduce the firm’s value and managers would, therefore, regard the situation as undesirable. It seems that in general, almost all risk management activities would be undesirable, since they reduce the hypothetical firm’s value. 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:
Table 5.2 Example of an Income Statement after Risk Management
|Before Change||After Change|
|Revenue||$1,000||1020||Customers satisfied with increased security increase purchases|
|Salaries||800||760||Employees satisfied with less|
|Interest on bonds||100||95||Creditors appreciate the improved security|
|Expected reported profit||100||125|
The profit (or expected profit) of the company has risen. If the owners continue to demand a tenfold multiplication factor, then the firm’s value increases from $1,000 to $1,250. The increase is a direct result of the new risk management policy, despite the introduction of the additional risk management or insurance costs. Note that the firm’s value has increased because other stakeholders (besides the owners) have enjoyed a change of attitude toward the firm. The main stakeholders affected include the credit suppliers in the capital market, the labor market and the product customers’ market. This did not happen as a result of improving the security of the stockholders but as a result of other parties benefiting from the firm’s new policy.
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. For example, if the new multiplier is eleven, the value of the firm would go up to $1,375 (125 × 11), relative to the original value of $1,000, which was based on a multiplier of ten.
This oversimplified example sheds a light on the practical complexity of measuring the risk manager’s performance, according to the modern approach. Top managers couldn’t evaluate the risk manager’s performance without taking into account all the interactions between all the parties involved. 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.g., standard accounting does not measure the fine changes that take place—such as the incremental effect of the new risk management policy on the sales, the salaries, or the creditors’ satisfaction). 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.
Risk managers may not always clearly define their goals, because the firm’s goals are not always clearly defined, especially for nonprofit organizations. Executives’ complex personal considerations, management coalitions, company procedures, past decisions, hopes, and expectations enter into the mix of parameters defining the firm’s goals. 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. Thus, it’s very important not to create a conflict between the risk managers’ interests and the firm’s interests. 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 2008–2009 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. As such, the risk manager’ job is to evaluate the firm’s ability or capacity to sustain (absorb) damages. This job requires in-depth knowledge of the firm’s financial resources, such as credit lines, assets, and insurance arrangements. With this information risk managers can compare alternative methods for handling the risks. We describe these alternative methods in the next section.
- In this section you studied the interrelationship between firms’ goals to maximize value and the contributions of the enterprise risk management function to such goals.
- We used a hypothetical income statement of a company.
- We also discussed the challenges in achieving firms’ goals under stakeholders’ many conflicting objectives.
- Discuss the different firm goals that companies seek to fulfill in the late 2000s.
- How does the risk management function contribute to firm goals?
- Find a company’s income statement and show how the enterprise risk management functions contribute at least two actions to increase the firm’s value.
- How might firm stakeholders’ goals conflict? How might such conflicting goals affect value maximization objectives?