ENTERPRISE RISK
MANAGEMENT
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ENTERPRISE RISK
MANAGEMENT
John Fraser
Betty J. Simkins
The Robert W. Kolb Series in Finance
John Wiley & Sons, Inc.
c 2010 by John Wiley & Sons, Inc. All rights reserved.
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Library of Congress Cataloging-in-Publication Data:
Fraser, John, 1946–
Enterprise risk management : today’s leading research and best practices for
tomorrow’s executives / John Fraser, Betty J. Simkins
p. cm. – (The Robert W. Kolb series in finance)
Includes index.
ISBN 978-0-470-49908-5 (cloth)
1. Risk management. I. Simkins, Betty J., 1957– II. Title.
HD61.F74 2010
658.15–dc22
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
Contents
Foreword by Robert S. Kaplan
PART I Overview
1
2
Enterprise Risk Management: An Introduction
and Overview
xix
1
3
What Is Enterprise Risk Management?
Drivers of Enterprise Risk Management
Summary of the Book Chapters
Overview
ERM Management, Culture, and Control
ERM Tools and Techniques
Types of Risks
Survey Evidence and Academic Research
Special Topics and Case Studies
Future of ERM and Unresolved Issues
Notes
About the Editors
3
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A Brief History of Risk Management
19
Introduction
Risk Management in Antiquity
After the Middle Ages
The Past 100 Years
Notes
About the Author
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3 ERM and Its Role in Strategic Planning
and Strategy Execution
Rising Expectations for Strategic Risk Management
ERM Positioned as Value-Adding
Board Demands for More Strategic Risk Management
Integrating Risk into Strategic Planning
Recognizing Strategic Business Risk
Evaluating Strategic Business Risk
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Contents
11 Tenets of the Return Driven Framework
Using a Framework to Build a Strategic Risk Management Mindset
Creating a Strategic Risk Mindset and Culture
A Strategic Risk Management Mindset
Recognizing Value of Strategic Risk Management at High-Performance
Companies
Building a Strategic Risk Assessment Process
Strategic Risk Management Processes
Focus on Genuine Assets at Risk
Strategic Risk Management and Performance Measurement
Critical Steps for Value-Added Strategic Risk Management
Conclusion
Notes
About the Authors
4 The Role of the Board of Directors and Senior
Management in Enterprise Risk Management
Introduction
Governance Expectations for Board Oversight of Risk Management
Delegation of Risk Oversight to Board Committees
Formalizing Risk Management Processes
Senior Executive Leadership in Risk Management
The Role of the Internal Audit Function in ERM
External Audit as an Independent Source of Key Risk Identification
ERM Implementation Strategies
Role of the Audit Committee
Role of the Board
Training
Board Composition
Reporting
Compliance
Culture
Conclusion
Notes
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PART II ERM Management, Culture, and Control
69
5 Becoming the Lamp Bearer: The Emerging Roles
of the Chief Risk Officer
71
The Origins of the CRO
The CRO as Compliance Champion
The CRO as Modeling Expert
The CRO as Strategic Controller
The CRO as Strategic Advisor
Which CRO Role to Play?
Conclusion
Notes
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CONTENTS
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7
vii
References
Acknowledgments
About the Author
82
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Creating a Risk-Aware Culture
87
The Importance of Culture
Defining Culture
The Goals of Culture
The Importance of Culture
When the Chips Are Down
Culture Can Discourage Good Risk Taking
Elements of a Risk-Aware Culture
Behavioral Elements
Process Elements
How to Create a Risk-Aware Culture
Defining the Elements
Measuring and Monitoring
Involvement and Buy-In
Openness
Tone from the Top
Alignment of Incentives and Rewards—Walking the Talk
What Does Risk Management Have to Do?
Conclusion
References
About the Author
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ERM Frameworks
97
Introduction
Introduction to the ISO Risk Management Framework
Principles of Risk Management and Excellence in Risk Management
Elements of an ERM Framework
ERM Framework: Concept and Elements
Risk Management Process (RMP)
Risk Management Process: Context
Risk Management Process: Risk Assessment
Risk Management Process: Risk Treatment
Risk Management Process: Monitoring and Review
Risk Management Process: Communication and Consultation
Risk Management Process: Recording the Risk Management Process
Mandate and Commitment to the ERM Framework
Rationale for Commitment to ERM
Gap Analysis for ERM
Context for ERM Framework
Design, Decision, and Implementation of the ERM Framework
Risk Management Policy
Policies for the ERM Framework
Policies for Risk Management Decisions
Review of Policies
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viii
Contents
Integration of Risk Management and Resources for ERM
Communications, Consultation, and Reporting
Accountability
Continuous Improvement
Conclusion
References
About the Author
8 Identifying and Communicating Key Risk Indicators
Introduction
What Is a Key Risk Indicator?
Definition
Examples of KRIs
Differentiation from Key Performance Indicators
Practical Applications
Validate Organizational Planning and Monitor Performance
Enhance Operational Efficiency and Effectiveness
Clarify Risk-Taking Expectations
Monitor Risk Exposures
Measure Risk
Value of KRIs to Risk Management
Design Principles
Keep the Stakeholders and Objectives in Mind
Leverage Management Insight and Existing Metrics
Have a Good Basic Understanding of the Risks
Limit Indicators to Those That Are Most Representative
Ensure Clarity in What Is Being Measured
Focus More on Objective Measures
Consider the Wider Set of KRIs
Consider the Relative Importance of KRIs
Monitor for Continual Usefulness
Think Longer Term
Implementation Considerations
Obtaining Buy-In
Lack of Resources and Skills
Data and Technology Challenges
Integration with Business Activities
Sustainability of the KRI Framework
Conclusion
Note
Acknowledgment
About the Author
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PART III ERM Tools and Techniques
141
9 How to Create and Use Corporate Risk Tolerance
143
Introduction
What Is Risk Tolerance?
143
144
CONTENTS
Why Is Setting Risk Tolerance Important?
What Are the Factors to Consider in Setting Risk Tolerance?
Attitude About Risk
Goals
Capability to Manage Risk
Capacity to Take Risk
Cost/Benefit of Managing Risk
How Can Your Organization Make Risk Tolerance Useful
in Managing Risk?
Conclusion
Notes
About the Authors
10
11
ix
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154
How to Plan and Run a Risk Management Workshop
155
Introduction
What Is a Risk Workshop?
Why Use Workshops?
How to Conduct a Risk Workshop
Preparation
Identify the Sponsor
Set the Objectives of the Workshop
Set the Scope
Assemble Reference Materials
Set the Agenda
Decide on Attendees
Arrange Venue
Execution
Facilitate the Workshop
Record the Results
Prepare the Final Report
Techniques for Planning and Facilitating Effective
Risk Workshops
“Anonymous” Voting
Useful Facilitation Tips
Tough Spots
Conclusion
About the Author
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How to Prepare a Risk Profile
171
Introduction
Definition and Uses of a Corporate Risk Profile
Common Types of Corporate Risk Profiles
The “Top 10” List
The Risk Map
The Heat Map
Advantages and Disadvantages of Information-Gathering
Methodologies
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x
Contents
How to Prepare a “Top 10” Risk Profile—Hydro One’s Experience
Step 1: Schedule Interviews and Gather Background Information
Step 2: Prepare the Interview Tools
Step 3: Summarize the Interview Findings
Step 4: Summarize the Risk Ratings and Trends
Step 5: Draft the Top 10 Risk Profile
Step 6: Review the Draft Risk Profile
Step 7: Communicate the Risk Profile with the Board
or Board Committee
Step 8: Track the Results
Conclusion
Notes
References
About the Author
12 How to Allocate Resources Based on Risk
Introduction
Risk Policy and a Center of Excellence for Risk Management
Key Policy Elements
Center of Excellence
Translating Strategic Objectives into Risk-Based Concepts
The Consequence Domain
The Probability Domain
The Integration of Business Objectives/Risk Events/Risk Concepts
Risk-Based Business Processes and Organizational Considerations
Risk-Based Business Processes
Organizational Considerations
Concepts, Methods, and Models Enabling Risk Identification,
Evaluation, Mitigation, Prioritization, and Management
The Concept of Evaluation Time Frames
Methods and Models to Quantify the Impact of Risk Events
Prioritization of Investment Proposals
Management of the Portfolio of Preferred Investment Proposals
Information Requirements and Challenges
Operational Risk Assessment Information
Strategic Risk Assessments
Measures of Effectiveness for Continuous Improvement
Conclusion
Notes
About the Author
Appendix 12.A
13 Quantitative Risk Assessment in ERM
Introduction
Risk Assessment: Four Alternative Approaches
Method 1: Active Management of the Largest Risks
Method 2: “High/Medium/Low” Classification of Risks:
The Two-Dimensional Risk Map
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CONTENTS
Method 3: Risk Assessment Using Refined Classifications:
Refining the Classification
Method 4: Statistical Analysis
Aggregating Probabilities and Impacts
Total Corporate Risk: An Illustration
Incorporating Risk Quantification in the Business Planning Process
Sensitivities and Scenarios
Conclusion
Notes
References
About the Author
PART IV Types of Risk
14
Market Risk Management and Common Elements
with Credit Risk Management
Introduction to Credit Risk and Market Risk
A Taxonomy of Market and Credit Risk
Credit and Market Risk in an ERM Framework
Responding to Credit and Market Risk
The Case for Actively Managing Market Risk
The Case for Not Actively Managing Market Risk
Natural Market Risk Management
Measuring Market Risk
The Markets as Risk Indicators
Measuring Potential Impact
Earnings at Risk
Market Risk Management with Forward-Type Products
Market Risk Management with Option-Type Products
Trade-Offs Between Option Strategies and Forward Strategies
Operational Issues of Using Derivatives
Governance and Oversight of Market Risk Management
Conclusion
Notes
References
About the Author
15
xi
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Credit Risk Management
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Credit Risk Analysis
Fundamental Analysis of Credit Default Risk (Probability of Default)
Market-Based Analysis of Credit Default Probability
Statistical-Based Models of Credit Risk
Credit Risk Mitigation
An Analysis of the Credit Crisis
Conclusion
Notes
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xii
Contents
References
About the Author
16 Operational Risk Management
Introduction
What Is Operational Risk and Why Should You Care About It?
Is Risk All Bad?
How Do You Assess Operational Risks, Particularly in a Dynamic
Business Environment?
Why You Need to Define Risk Tolerance for Aligned Decision Making
What Can You Do to Effectively Manage Operational Risk?
How Do You Encourage a Culture of Risk Management
at the Operational Level?
How Do You Align Operational Risk Management with Enterprise
Risk Management?
Conclusion
Notes
About the Author
17 Risk Management: Techniques in Search of a Strategy
Introduction
Current Situation
Risk Strategy Framework
Governance
New Directions
Enterprise Risk Management (ERM): The First Step
Enterprise Resilience (ER): The Next Step?
Conclusion
Notes
References
About the Author
18 Managing Financial Risk and Its Interaction
with Enterprise Risk Management
Introduction
What Is Financial Risk and How Is It Managed?
Case 1: Currency Price Risk: The Multinational Corporation
Case 2: Interest Rate Risk: The “Heavy-Debt” Firm
Case 3: Commodity Price Risk: The Firm with a Highly
Volatile Input Cost
Theoretical Underpinnings of Financial Hedging
and Empirical Findings
Hedging Reduces Expected Costs of Financial Distress
and Underinvestment
Hedging Creates More Debt Capacity
Hedging Reflects the Incentives of the Firm’s Management and Board
Does Hedging Affect Firm Value?
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CONTENTS
Interaction of Financial Hedging with Other Types
of Risk Management
Credit Risk Management
Operational Risk Management
Strategic Risk Management
Reputation and Legal Risk Management
Financial Reporting and Disclosure Risk Management
What Can We Learn About ERM Given Our Knowledge
of Financial Hedging?
Notes
References
About the Author
19
20
21
Bank Capital Regulation and Enterprise
Risk Management
xiii
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Introduction
The Evolution of Bank Capital Requirements
Overview of U.S. Capital Ratios
Basel I
Basel II
Enterprise Risk Management (ERM) and Economic Capital
Conclusion
Notes
References
About the Author
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349
Legal Risk Post-SOX and the Subprime Fiasco:
Back to the Drawing Board
351
Introduction
The Legal Framework of Legal and Reputational Risk Management
The Federal Rules of Professional Responsibility for Attorneys
Whistle-Blower Protection Under Sox
Audit Reform
Codes of Conduct
An Assessment of the SOX Framework on Legal
and Reputational Risk
The Subprime Fiasco
The SOX Shortcomings
Toward Optimal Reputational and Legal Risk Management
Conclusion
Note
References
About the Author
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Financial Reporting and Disclosure Risk Management
369
The Importance of Disclosure Management and ERM
Foundations in the United States
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xiv
Contents
Disclosure and Sarbanes-Oxley
New Group for Reporting: Public Company Accounting
Oversight Board
Important SOX Sections
Section 404: Internal Controls and Compliance Management
Section 302: Who Is Responsible for Financial Reporting?
Other Financial Reporting
Accounting for Derivatives—FASB 133
Firm Choice for FASB 133 and Disclosure Risk Management
Risk Identification, Monitoring, and Reporting
Financial Reporting Challenges Today
Paring Down Internal Control: Auditing Standard 5 (AS5)
Global Financial Crisis and ERM
Reexamining Fair Value Accounting: FASB 157
Conflicts with International Standards: Rules versus Principles
Adding ERM to Company Credit Ratings
Conclusion
Notes
References
About the Author
PART V Survey Evidence and Academic Research
22
Who Reads What Most Often?: A Survey of Enterprise
Risk Management Literature Read by Risk Executives
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Introduction
Survey Methodology
Survey Results
Survey Respondent Profile
ERM Tools and Techniques Used by Respondents
Most Frequently Read Literature on ERM
Critical Areas of Need
Key Findings of Our Survey
Conclusion
Appendix 22.A: Publications Included in the Survey
Appendix 22.B: Survey Respondents Who Gave Permission
to Be Identified
Notes
References
About the Authors
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23 Academic Research on Enterprise Risk Management
419
Introduction
Academic Research on Enterprise Risk Management
Colquitt, Hoyt, and Lee (1999)
Kleffner, Lee, and McGannon (2003)
Liebenberg and Hoyt (2003)
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CONTENTS
xv
Beasley, Clune, and Hermanson (2005a)
Beasley, Clune, and Hermanson (2005b)
Desender (2007)
Beasley, Pagach, Warr (2008)
Pagach and Warr (2008a)
Pagach and Warr (2008b)
Gates, Nicolas, and Walker (2009)
Case Studies on ERM
Harrington, Niehaus, and Risko (2002)
Aabo, Fraser, and Simkins (2005)
Stroh (2005)
Acharyya and Johnson (2006)
Nocco and Stulz (2006)
Conclusion
Notes
References
About the Authors
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Enterprise Risk Management: Lessons from the Field
441
Introduction
Lessons from the ERM Process
Clarifying Strategies and Objectives
Identifying Risks
Assessing Risk
Acting on the Risks
Monitoring Risks
Lessons from Integrating ERM with Ongoing
Management Initiatives
Strategic Planning and ERM
The Balanced Scorecard and ERM
Budgeting and ERM
Internal Auditing and ERM
Business Continuity Planning, Crisis Preparedness, and ERM
Corporate Governance and ERM
Some Key Value Lessons from ERM
Conclusion
Notes
References
Further Reading
About the Authors
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PART VI Special Topics and Case Studies
25
Rating Agencies’ Impact on Enterprise
Risk Management
Introduction
Banking: General
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Contents
Insurance: S&P
Insurance: Moody’s
Insurance: Fitch
Insurance: A.M. Best
U.S. Energy Companies: S&P
Nonfinancial Companies: S&P
A Fly in the Ointment
Conclusion
Notes
Further Reading
About the Author
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26 Enterprise Risk Management:
Current Initiatives and Issues
479
Question 1
Question 2
Question 3
Question 4
Question 5
Question 6
Question 7
Question 8
Notes
27 Establishing ERM Systems in Emerging Countries
Introduction
Enterprise Risk Management and Its Benefits in Emerging Markets
Evolution of Risk Management in Emerging Markets
The Rationale for Effective Risk Management in Emerging Markets
The Responsibility of the Board in Risk Management and Extensions
to Emerging Markets
Risk, Reward, and Risk Appetite in Emerging Markets
Observations of ERM Practices in Emerging Countries
Conclusion
Appendix: COSO Approach to Enterprise Risk Management
Notes
References
About the Author
28
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The Rise and Evolution of the Chief Risk Officer:
Enterprise Risk Management at Hydro One
531
Hydro One
Getting Started with ERM
Corporate Risk Management Group
Pilot Study
Final Approval
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CONTENTS
Processes and Tools
The Business Context
Identification and Assessment of Risks and Controls
Tolerability of Risk—and Risk Mitigation
Monitor and Review
Corporate Risk Profile
Description of Risk Sources
Quantifying the Unquantifiable
Benefits of ERM and Outcomes at Hydro One
Current Status
Conclusion
Notes
About the Authors
Index
xvii
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Foreword
am pleased to welcome this important collection of authoritative papers on
enterprise risk management. This subject has, unfortunately, operated below
the visibility screen of most CEOs for many years. In the financial institutions,
where regulations require a risk management process, most bank CEOs viewed it as
a compliance process, much like internal audit and internal controls. They did not
view risk management as a strategic process nor one that demanded much of their
time and attention. As a consequence, most businesses have limited ability to assess
its risk from rapid growth, increased complexity in financing and securitization,
and globalization. Company executives have not been the only ones failing to
pay sufficient attention to the topic. Few MBA, accounting, or finance programs
departments featured courses and training in enterprise risk management.
The events of 2007–2009 have made the gaps in knowledge, training, and attention to risk management abundantly clear, albeit in a highly costly and tragic
manner. Businesses, business schools, regulators, and the public are now scrambling to catch up with the emerging field of enterprise risk management. This
subject must become a priority for students to study, executives to practice, and
regulators to verify. Fraser and Simkins have produced an impressive contribution
to the field, one that I believe will help to educate many. I hope this book, beyond
its educational and attention-directing mission, will also stimulate the production
of other articles and books so that a common body of knowledge can be developed
for this vital profession. We are indebted to John Fraser and Betty Simkins for
organizing the impressive author team and the editing of this book.
I
ROBERT S. KAPLAN
Baker Foundation Professor
Harvard University
xix
ENTERPRISE RISK
MANAGEMENT
PART I
Overview
CHAPTER 1
Enterprise Risk Management
An Introduction and Overview
JOHN R.S. FRASER
Vice President, Internal Audit & Chief Risk Officer, Hydro One Networks Inc.
BETTY J. SIMKINS
Williams Companies Professor of Business and Professor of Finance, Oklahoma State
University
It’s not the strongest of the species that survive, nor the most intelligent, but those that are
the most responsive to change.
—Charles Darwin
WHAT IS ENTERPRISE RISK MANAGEMENT?
Enterprise risk management (ERM) can be viewed as a natural evolution of the
process of risk management. The Committee of Sponsoring Organizations of the
Treadway Commission (COSO) defines enterprise risk management as: “. . . a process, effected by an entity’s board of directors, management and other personnel,
applied in strategy setting and across the enterprise, designed to identify potential
events that may affect the entity, and manage risk to be within its risk appetite,
to provide reasonable assurance regarding the achievement of entity objectives.”
The COSO definition is intentionally broad and deals with risks and opportunities
affecting value creation or preservation. Similarly, in this book, we take a broad
view of ERM, or what we call—a holistic approach to ERM.
Some sources have referred to ERM as a new risk management paradigm.
As in the past, many organizations continue to address risk in “silos,” with the
management of insurance, foreign exchange, operations, credit, and commodities
each conducted as narrowly focused and fragmented activities. Under ERM, all
risk areas would function as parts of an integrated, strategic, and enterprise-wide
system. And while risk management is coordinated with senior-level oversight,
employees at all levels of the organization using ERM are encouraged to view risk
management as an integral and ongoing part of their jobs.
The purpose of this book is to provide a blend of academic and practical
experience on ERM in order to educate practitioners and students alike about this
3
4
Overview
evolving methodology. Furthermore, our goal is to provide a holistic coverage of
ERM, and in this process, provide the “‘what,” “why,” and “how” of ERM to assist
firms with the successful implementation of ERM.
The chapters that follow are from some of the leading academics and practitioners of this new methodology, with the in-depth insights into what practitioners
of this evolving business practice are actually doing, as well as anticipating what
needs to be taught on this topic. The leading experts in this field clearly explain
what enterprise risk management is and how you can teach, learn, or implement
these leading practices within the context of your business activities.
Enterprise Risk Management introduces you to the wide range of concepts and
techniques for managing risk in a holistic way, by correctly identifying risks and
prioritizing the appropriate responses. It offers a broad overview of the different
types of techniques: the role of the board, risk tolerances, risk profiles, risk workshops, and allocation of resources, while focusing on the principles that determine
business success. This comprehensive resource also provides a thorough introduction to enterprise risk management as it relates to credit, market, and operational
risks, and covers the evolving requirements of the rating agencies and their importance to the overall risk management in a corporate setting. As well, it offers a
wealth of knowledge on the drivers, the techniques, the benefits, and the pitfalls
to avoid, in successfully implementing enterprise risk management.
DRIVERS OF ENTERPRISE RISK MANAGEMENT
There are theoretical and practical arguments for the use of ERM. As outlined in
Chapter 2 there has been an increasing consciousness in risk literature that a more
holistic approach to managing risk makes good business sense.
External drivers for its implementation have been studies such as the Joint
Australian/New Zealand Standard for Risk Management,1 the Committee of Sponsoring Organizations of the Treadway Commission (COSO),2 the Group of Thirty
Report in the United States (following derivatives disasters in the early 1990s),3
CoCo (the Criteria of Control model developed by the Canadian Institute of Chartered Accountants),4 the Toronto Stock Exchange Dey Report in Canada following
major bankruptcies,5 and the Cadbury report in the United Kingdom.6
Major legal developments such as the New York Stock Exchange Listing Standards and the interpretation of the recent Delaware case law on fiduciary duties,
among others, have provided an additional force for ERM.7 In addition, large
pension funds have become more vocal about the need for improved corporate
governance, including risk management, and have stated their willingness to pay
premiums for stocks of firms with strong independent board governance.8 ERM
has also increased in importance due to the Sarbanes-Oxley Act of 2002—which
places greater responsibility on the board of directors to understand and monitor
an organization’s risks.
Finally, it is important to note that ERM can increase firm value.9 Security rating
agencies such as Moody’s and Standard & Poor’s include whether a company has
an ERM system as a factor in their ratings methodology for insurance, banking,
and nonfinancial firms.
ENTERPRISE RISK MANAGEMENT
5
SUMMARY OF THE BOOK CHAPTERS
As mentioned earlier, the purpose of this book is to provide a blend of academic and
practical experience on ERM in order to educate practitioners and students alike
about this evolving methodology. Furthermore, our goal is to provide a holistic
coverage of ERM, and in this process, provide the what, why, and how of ERM to
assist firms with the successful implementation of ERM. To achieve this goal, the
book is organized into the following sections.
Overview
ERM Management, Culture, and Control
ERM Tools and Techniques
Types of Risks
Survey Evidence and Academic Research
Special Topics and Case Studies
A brief description of the author(s) and the chapters is provided below.
Overview
In Chapter 2, “A Brief History of Risk Management,” we ask Felix Kloman—retired
risk management consultant, conceptual thinker, and lover of sailing—to provide
the background and history of risk management and the evolution of enterprise
risk management. Felix was ideally suited to do this as someone who has dedicated more than 30 years to sharing stories, raising interesting risk concepts, and
generally enjoying the challenges of this entire field. There is no one we know who
is better suited or knows more about this topic. He takes us right back literally to
some of the earliest recorded thinking on risk management and brings us through
the ages to current thinking. Felix goes back to the basic questions of “What is risk
management? When and where did we begin applying its precepts? Who were the
first to use it?” He provides a highly personal study of this discipline’s past and
present. It spans the millennia of human history and concludes with a detailed
list of contributions in the past century. This is an ideal starting point for anyone
new to the topic of risk management or the older scholars who wish to revisit this
easy-to-read summary of risk. Felix is adamant in his view that risk must consider
opportunities as well as threats.
“ERM and Its Role in Strategic Planning and Strategy Execution” is presented
in Chapter 3 by Mark L. Frigo (Director, the Center for Strategy, Execution, and
Valuation and Ledger & Quill Alumni Foundation, Distinguished Professor of
Strategy and Leadership at the DePaul University Kellstadt Graduate School of
Business and School of Accountancy, Chicago) and Mark S. Beasley (Deloitte Professor of Enterprise Risk Management and Professor of Accounting in the College
of Management at North Carolina State University, and Director of North Carolina State’s Enterprise Risk Management Initiative). The authors have captured
the essence of leading ERM and strategic risk management initiatives at their universities as well as their work with hundreds of practice leaders in enterprise risk
management. They recognize that one of the major challenges in ensuring that
6
Overview
risk management is adding value is to incorporate ERM in business and strategic
planning of organizations. They explain how focusing on strategic risks serves as
a filter for management and boards of directors to reduce the breadth of the risk
playing field and ensure that they are focused on the right risks. These insights
should help respond to the numerous calls following the recent credit crisis for
improvements in overall risk oversight, with a particular emphasis on strategic
risk management.
In Chapter 4, “The Role of the Board of Directors and Senior Management
in Enterprise Risk Management,” Bruce Branson (Professor and Associate Director, Enterprise Risk Management Initiative, North Carolina State College of Management) explains that the oversight of the enterprise risk management process
employed by an organization is one of the most important and challenging functions of a corporation’s board of directors. He notes that a failure to adequately
acknowledge and effectively manage risks associated with decisions being made
throughout the organization can and often do lead to potentially catastrophic results. Bruce explains the shared responsibility between the members of the board
and the senior management team to nurture a risk aware culture in the organization that embraces prudent risk taking within an appetite for risk that aligns with
the organization’s strategic plan. He identifies the legal and regulatory framework
that drives the risk oversight responsibilities of the board. He also clarifies the
separate roles of the board and its committees vis-à-vis senior management in the
development, approval, and implementation of an enterprise-wide approach to
risk management. Finally, the chapter explores optimal board structures to best
discharge their risk oversight responsibilities.
ERM Management, Culture, and Control
Anette Mikes (Assistant Professor of Business Administration at Harvard Business
School) provides insights into the types of roles that CROs play, based on her
personal research in Chapter 5, “Becoming the Lamp Bearer: The Emerging Roles
of the Chief Risk Officer.” Anette gained her PhD in enterprise risk management
from the London School of Economics, and is setting up a program at Harvard
Business School with Robert Kaplan to teach ERM. Anette describes the role of
chief risk officers (CRO) and different types of ERM methodologies that she sees
in practice. She draws on the existing practitioner and academic literature on the
role of chief risk officers, and a number of case studies from her ongoing research
program on the evolution of the role of the CRO. Anette describes the origins and
rise of the CRO, and outlines four major roles that senior risk officers may fulfill:
(1) the compliance champion; (2) the modeling expert; (3) the strategic advisor; and
(4) the strategic controller. She demonstrates how chief risk officers could improve
business decision making and incorporate both good risk analytics and expert
judgment, as well as influence risk-taking behavior in the business lines. As she
explains: “The art of successful risk management is in getting the executive team
to see the light and value the lamp-bearer.” This chapter will be of great interest to
all CROs and those organizations thinking about how to implement ERM.
“Creating a Risk-Aware Culture” is discussed in Chapter 6 by Doug Brooks
(President and CEO, Aegon Canada Inc.). The author draws on his actuarial training and business insights to provide the methods to create a positive culture for risk
ENTERPRISE RISK MANAGEMENT
7
management in any organization. The actuarial profession has for several years
recognized and been a leading advocate for the research and expansion of ERM
into their organizations. Actuaries are by training and experience well versed in
managing risks and have expanded into additional areas such as investments and
know how best to apply ERM concepts. We wanted to ensure the actuarial profession was included in this book and were delighted when we approached Doug
Brooks that he suggested writing about the role of culture in risk management.
Doug has been one of the early pioneers in ERM and this has likely added to his
continued professional success, as he was recently appointed President and CEO of
Aegon Canada Inc. Doug observes that an organization could possess world-class
technical capabilities and strong processes for collecting and reporting information, but still have a bankrupt culture so that no value was added through ERM
efforts. He considers that there is nothing more crucial to the success of ERM efforts
in an organization than an informed and supportive culture. He points out that
culture is not merely an intangible concept, but that its elements can be defined
and progress in moving toward a desired culture can be measured. He notes that
to be successful in risk management, organizations must recognize the importance
of encouraging and rewarding disciplined behaviors, as well as openness in communication. Culture is key to ERM and this chapter is helpful to all practitioners
who are implementing ERM.
Chapter 7, “ERM Frameworks,” is authored by one of the leading authorities on risk frameworks, Professor Emeritus John Shortreed of the University of
Waterloo, Canada. Professor Shortreed provides a forward-looking view at the
forthcoming international framework for risk management. He is the Canadian
representative on the committee that has developed the new ISO 31000 Risk Management Standard (due to be published around the same time as this book). This
chapter is a great “companion” for those using the new ISO 31000 standard. Historically, ERM has been molded by the Australian/New Zealand Risk Standard
4360, by COSO’s 2004 publication, and recent pronouncements of rating agencies
such as Standard & Poor’s; however, this new ISO standard is expected to have
greater international acceptance in years to come. This chapter describes the new
ISO risk management framework, which incorporates best practice from COSO,
PMI (Project Management Institute), the Australian and New Zealand Standard
(AS/NZS 4360:2004) and other leading international risk management standards.
John notes that an ERM framework can often be implemented in a step-by-step
way and this approach will assist in building acceptance of ERM and in encouraging a risk culture, particularly if potentially successful areas are selected for
the first steps. As the risk management culture matures in the organization there
should be noticeable improvements in the ability to discuss risks easily, decision
making under uncertainty, comfort levels with risk situations, and achievement of
objectives.
Susan Hwang (Associate Partner, Deloitte, Toronto, Canada) provides some
original views on the role of Key Risk Indicators (KRIs) in Chapter 8 “Identifying
and Communicating Key Risk Indicators.” Since 2000 when Hydro One first began
practicing ERM, there have not been a lot of new concepts introduced, despite
the numerous publications on the topic. A year or two ago, John Fraser was at
a presentation made by Susan Hwang on the topic of KRIs and realized that she
was describing a concept that we had not seen before. She demonstrated how to
8
Overview
use metrics, or what were often packaged among Key Performance Indicators, as a
means of identifying evolving risks that might arise or increase in the future. This is
a seemingly simple concept but one that we thought to be important to identifying
future key risks. We found that virtually nothing had been written on the topic
before, so we asked Susan to write this chapter and share her findings and views.
Susan notes that the formal use of KRIs as an ERM tool is an emerging practice.
Although many organizations have developed key performance indicators as a
measure of progress against the achievement of business goals and strategies, this
differs from using KRIs to support risk management and strategic and operational
performance. In this chapter, Susan clarifies what KRIs are and demonstrates their
practical applications and value to an organization. She outlines the guiding principles for designing KRIs, and discusses implementation and sustainability. The
key message she shares is that there are lots of metrics and performance measures
in any organization, but the art of ERM is identifying the key ones that will help
identify future risks.
ERM Tools and Techniques
“How to Create and Use Corporate Risk Tolerance” is presented in Chapter 9 by
Ken Mylrea (Director, Corporate Risk, Canada Deposit Insurance Corporation) and
Joshua Lattimore (Policy and Research Advisor, Canada Deposit Insurance Corporation). The authors explore and provide practical examples of the role of risk
tolerances. John first learned of Canada Deposit Insurance Corporation (CDIC) in
the early 1990s when CDIC issued expectations about the business and financial
practices of its member institutions. These principle-based standards were developed by Ken Mylrea and focus on enterprise-wide governance and management.
Their underlying premise was that well-managed institutions are less likely to encounter difficulties that could result in CDIC having to pay the claims of depositors.
A key feature of the standards was the requirement that institutions’ management
and board of directors perform a self-assessment against the CDIC control criteria
and report the results to the CDIC. In setting the context for this chapter, Ken and
Joshua pose the following questions: What is risk tolerance? Why is setting risk
tolerance important? What are the factors to consider in setting risk tolerance? And
how can you make risk tolerance useful in managing risk? They describe risk tolerance as the risk exposure an organization determines appropriate to take or avoid
taking, that is, risk tolerance is about taking calculated risks—namely, taking risks
within clearly defined and communicated parameters set by the organization.
In Chapter 10, “How to Plan and Run a Risk Management Workshop,” Rob
Quail (Outsourcing Program Manager at Hydro One Networks Inc.) provides hardhitting practical advice on how to actually design and run a risk workshop. Rob
was a major reason for the success of ERM at Hydro One and its sustainability to
date. He has run more than 200 risk workshops at all levels, including facilitating
meetings of up to 800 staff! When we were designing this book we realized that
there was nothing we could find documented elsewhere on how to design and run
a risk workshop. Rob describes in an easy step-by-step fashion how to design workshops based on the objectives to be achieved, for example, how important is team
building versus specific action planning? Rob explains that risk workshops play a
vital role in ERM by helping engage executive managers and staff in understanding
ENTERPRISE RISK MANAGEMENT
9
the corporate objectives and the risks to achieving these within given tolerances.
He goes on to show how workshops not only help identify and address critical
risks, but also provide opportunities for participants to learn about organizational
objectives, risks, and mitigants. He makes it clear that one size does not fit all and
each workshop has to be designed carefully depending on the circumstances and
desired outcomes.
In Chapter 11, “How to Prepare a Risk Profile,” John Fraser (Vice President,
Internal Audit & Chief Risk Officer at Hydro One) provides practical advice on
how to prepare a risk profile for executive management and the board of directors.
We wanted to have a chapter on risk profiles, and while there is a lot written
about risk maps, heat maps, and risk identification, we could not find anything
specific about how to actually conduct structured interviews and prepare a risk
profile. As a result, we decided to document the Hydro One model, which we have
been using since 1999, and which has been proven to be simple and effective. This
methodology is based primarily on interviews with executives and risk specialists
and complements the results captured by risk workshops. Ideally the results of
workshops and interviews (or surveys) should be consolidated and reconciled.
It is our hope that these step-by-step instructions will give confidence to risk
managers implementing ERM on how best to conduct these interviews effectively.
As Sir Graham Day, who was an early champion of ERM at Hydro One, told John
“ERM obviously works in practice but can you make it work in theory?”
Chapter 12, “How to Allocate Resources Based on Risk,” by Joe Toneguzzo
(Director—Implementation & Approvals, Power System Planning, Ontario Power
Authority) outlines a business framework for prioritizing resources based on
risks, as part of the business planning process. Soon after we began implementing
ERM at Hydro One, Joe Toneguzzo—who was responsible for obtaining funding and allocating resources for asset management—worked with the Hydro One
Corporate Risk Management Group to determine how best to do so utilizing a
risk-based approach. (Joe is now with another organization.) A methodology and
supporting business process was developed that has served Hydro One well and
is regarded as a leading asset management resource allocation model, as validated
in international forums on this subject area. The concept involves identifying the
critical business risks and the expenditures proposals available to mitigate them.
This is followed by rating all the expenditure proposals in a consistent manner
based on the risks that will be mitigated per unit of cost. The expenditures proposals are then dispatched on a priority basis, based on cost/benefit scores (where the
benefit is measured in terms of reduced risk) until the resources are exhausted. The
advantages of the methodology developed are that it is transparent, consistent, and
easy to justify to stakeholders such as regulators, boards of directors, and others.
Joe takes us through the theory and practice in an easy-to-follow manner.
John Hargreaves (Managing Director, Hargreaves Risk & Strategy, London,
England) explores and provides guidance on the popular topic of quantifying
risks in Chapter 13, “Quantitative Risk Assessment in ERM.” John Hargreaves has
seen his ideas and expertise implemented in various major organizations in England and brings an easy-to-understand introduction to what can become complex
theories. John enjoyed a successful career in the real world of finance with major
organizations, including being responsible for introducing risk management systems in a major bank following the last U.K. depression. Over the last 10 years, he
10
Overview
has helped implement risk management systems in about 60 organizations. This
chapter explains the complex world of quantification of risks in progressive steps
to help those who are new to ERM. John provides descriptions of four differing
approaches to the quantification of individual risks. Statistical methods for calculating and reporting a company’s total corporate risk are described and illustrated
by a simple example and he also shows how quantified risks may be incorporated
in the business planning process. Note that specialized methods to quantify risks
in financial institutions are not covered here. His chapter is a must-read for anyone
interested in the theory of practical and workable methods for quantifying risks.
Types of Risks
In Chapter 14, “Market Risk Management and Common Elements with Credit
Risk Management,” Rick Nason (Partner, RSD Solutions, and Associate Professor
of Finance, Dalhousie University, Nova Scotia) explains very sophisticated trading
and market risk concepts and risk management methods in an easy-to-understand
format. Rick left the exciting world of derivatives trading at a major Canadian
bank to join the even more exciting world of academia where he is sharing his
experiences through his teaching and consulting activities. Although comfortable
with the complex models and math for market risk and derivatives, Rick decided
to write this chapter for the general practitioner who wants to learn about market
risk management and how it relates to credit risk management. In this chapter,
Rick describes how to consider these risks and a framework that provides a focus
on market risk. Rick points out that market risk management requires not only an
understanding of the tools and techniques, but also of the underlying business in
order to successfully implement the market risk function within the enterprise risk
management framework of the organization.
Continuing his discussion from the previous chapter, Rick Nason provides
the basic elements of credit risk management as well as the more sophisticated
concepts every credit risk manager should understand in Chapter 15, “Credit Risk
Management.” Each year, Rick runs a credit competition at the university, as well as
consulting with major banks on ERM and credit risk management. Rick explains
that when conducting credit analysis, it is important to remember that, unlike
market risk, credit risk is almost always a downside risk; that is, unexpected credit
events are almost always negative events and only rarely positive surprises. He
also reminds the reader that no one extends credit to a customer, or executes a loan
to a counterparty, expecting that it will not be repaid. Rick has crafted this chapter
for the general practitioner who wants to learn about credit risk management and
for the more experienced credit managers seeking to validate their approach.
Diana Del Bel Belluz (President, Risk Wise Inc.) explains operational risk concepts and methods in an easy-to-read format that will be essential to any student
of ERM and helpful to more experienced readers in Chapter 16, “Operational Risk
Management.” Diana has taught risk management since 1992 and has a background
in decision science. With her broad experience from her consulting practice, she
understands the challenges of a wide variety of organizations in getting a handle
on this multifaceted topic. In this chapter, Diana explains the fundamentals of risk
management in an operational setting and how operational risk management can
be used to capture the full performance potential of an organization. She explores
ENTERPRISE RISK MANAGEMENT
11
what is meant by operational risk and why it is important. She frames her explanations around questions such as: How do you align operational risk management
with enterprise risk management? How do you assess operational risks? Why do
you need to define risk tolerance for aligned decision making? What can you do
to manage operational risk? How do you encourage a culture of risk management
at the operational level? This chapter provides a well-rounded introduction to a
topic that is becoming of increasing interest.
In Chapter 17, “Risk Management: Techniques in Search of a Strategy,” Joseph
V. Rizzi (Senior Investment Strategist, CapGen Financial Group, New York) explores the reasons for the losses that triggered massive shareholder value destruction resulting in dilutive recapitalizations, replacement of whole management
teams, the failure of numerous institutions, and the adoption of the $700 billion
TARP rescue program, and what can be done to avoid this in future. He suggests
that risk management needs to move away from a technical, specialist control
function with limited linkage to shareholder value creation. This can be achieved
by firms and risk decisions moving from an internal egocentric focus to an external
systems approach incorporating the firm within a market context. Further, he states
that we need to move beyond risk measurement to risk management that integrates
risk into strategic planning, capital management, and governance. Joseph draws
on Warren Buffett’s principles and numerous practical examples (including Long
Term Capital Management) to explain, using charts and models, how governance
and ERM can address many of the pitfalls we have seen.
Daniel A. Rogers (Associate Professor of Finance, School of Business Administration, Portland State University) provides in Chapter 18, “Managing Financial
Risk and Its Interaction with Enterprise Risk Management,” a useful background
on financial risk management, namely corporate strategies of employing financial
transactions to eliminate or reduce measurable risks. He includes possible definitions and examples of industry applications of financial hedging. He then moves
on to a basic review of the theoretical rationales for managing (financial) risk and
explores the potential for the interaction of financial hedging with other areas of
risk management (such as operational, strategic). He also discusses the lessons that
can be applied to ERM from the knowledge base about financial hedging. He points
out that active board involvement and buy-in are critical to the implementation of
a successful ERM program, and that boards that better understand financial risks
are likely to be more receptive to conversations about other significant risks that
could negatively affect company performance.
Benton E. Gup (Robert Hunt Cochrane/Alabama Bankers Association Chair of
Banking at the University of Alabama) traces the evolution of bank capital requirements in Chapter 19, “Bank Capital Regulation and Enterprise Risk Management,”
from the 1800s to the complex models used in Basel I and II. He points out that
the recent subprime crisis makes it clear that our largest banks and financial institutions do not have adequate risk management as evidenced by problems with
major banks and that the models employing economic capital can be subject to
large errors. He goes on to introduce enterprise risk management and economic
capital, which he believes represent the future of bank capital. He notes that enterprise risk management uses a “building block” approach to aggregate the risks
from all lines of business, and that economic capital must be “forward looking,”
and based on expected scenarios instead of recent history.
12
Overview
In “Legal Risk Post-SOX and the Subprime Fiasco: Back to the Drawing Board”
(Chapter 20), Steven Ramirez (Director, Business & Corporate Governance Law
Center, Loyola University, Chicago) notes that legal risk should be managed in
accordance with basic notions of risk management generally. He points out that it
should not exist within a risk silo, but should be managed with a view toward the
firm’s overall risk tolerance and through coordinated efforts of senior management,
as well as the board. Professor Ramirez explains in a “no holds barred” way how
the rules of professional responsibility governing lawyers were flawed, corporate
law was stunted, whistle-blowing was not encouraged, codes of conduct were
wholly optional, and there was insufficient regulation of the audit function. This
chapter reviews the most developed framework governing legal and reputational
risk (SOX) and suggests innovative and proactive ways that controls could be
improved and risk can be reduced in the future.
“Financial Reporting and Disclosure Risk Management” is discussed extensively by Susan Hume, Assistant Professor of Finance and International Business,
School of Business, the College of New Jersey) in Chapter 21. The author boils
down the key requirements of the extensive regulations for financial reporting and
disclosure into an easy-to-understand chapter. Key topics such as reporting on
internal controls under Sarbanes-Oxley, accounting for derivatives, and fair value
accounting are discussed and explained. Susan explains how ERM reporting and
disclosure provides the forum to discuss the key vulnerabilities and risks of the firm
and strengthens management accountability. It is for the board and senior management to set the risk policy, establish the key levels of acceptable risk exposure, and
communicate these policies to managers and other employees. Implementation
and reporting then flows up from the bottom to senior management and to the
risk management committee, which may be a subcommittee of the board in the
ideal structure. This chapter will be an ideal place to gain an introduction to these
complex requirements as well as add helpful insights for the more experienced
reader.
Survey Evidence and Academic Research
John Fraser and Betty Simkins (co-editors of this book) teamed with Karen
Schoening-Thiessen (Senior Manager of Executive Networks in the Governance
and Corporate Responsibility Group at the Conference Board of Canada) to develop and analyze the first survey evidence of risk executives working in the area
of ERM about the literature they find most effective in assisting and facilitating the
successful implementation of ERM. The study in Chapter 22, “Who Reads What
Most Often?” highlights crucial areas of need on ERM, and it is hoped that these
will be a starting point to encourage and stimulate more advances in the research
and practice of ERM. It highlights excellent opportunities for academics to closely
collaborate with practitioners to conduct research in these key areas of need. The
chapter also discusses problems and challenges risk executives have encountered
that were not addressed in the literature. Detailed listings are provided of the top
readings of articles (i.e., surveys, academic studies, and practitioner articles), books,
and research reports. This chapter was originally published in the Spring/Summer
2008 issue of the Journal of Applied Finance.
ENTERPRISE RISK MANAGEMENT
13
Chapter 23, “Academic Research on Enterprise Risk Management,” by Subbu
Iyer (PhD student, Oklahoma State University), Daniel A. Rogers (Associate Professor, Portland State University), and Betty Simkins (Williams Companies Professor
of Finance, Oklahoma State University), provides a summary to date of research
on enterprise risk management. To conduct the review, they searched academic
journals and other databases of academic research and limited their focus to papers that can be classified as either academic research or case studies that would
be appropriate for a classroom setting. After a thorough search of ERM literature,
the authors located 10 research studies and 5 case studies to synthesize. Overall,
the authors find little in the way of consistent results about ERM. In addition,
they find that more case studies on enterprise risk management are needed so that
risk executives can learn from the experiences of others who have successfully
implemented it.
In Chapter 24 “Enterprise Risk Management: Lessons from the Field,” we have
the benefit of the knowledge from a trio of experienced ERM experts, namely:
William G. Shenkir (William Stamps Farish Professor Emeritus, University of
Virginia’s McIntire School of Commerce), Thomas L. Barton (Kathryn and Richard
Kip Professor of Accounting, University of North Florida) and Paul L. Walker
(Associate Professor of Accounting, University of Virginia). The authors of this
chapter have been involved in the area of ERM since 1996. They have taught ERM
at the undergraduate and graduate levels and for businesses and executives worldwide as well as consulting on ERM implementation. They point out that one of
the early lessons that companies glean from ERM is that many layers of the company, including senior management, operating managers, and regular employees
do not know or understand the strategies and objectives of the organization and
how these, in turn, relate to their daily job and tasks. ERM compels companies to
identify and focus on the organization’s strategies and objectives. This chapter is
illustrated with numerous real-life examples and provides a wonderful lesson in
what enterprise risk management is like in real life.
Special Topics and Case Studies
In Chapter 25, “Rating Agencies Impact on Enterprise Risk Management,” Mike
Moody (Managing Director, Strategic Risk Financing Inc.) provides the history and
current published thinking of the major rating agencies. This is an area that we
expect will expand and become more established as time goes on. Mike has an
MBA in finance, is the Managing Director of a risk consulting firm, and was a
risk manager of a Fortune 500 company. He has a broad view of the risk universe
and what is happening due to the activities of the rating agencies. The interest
taken by the agencies, especially Standard & Poor’s (S&P) in recent years, has
focused boards and senior management on the need for and the advantages of
ERM. Mike notes that one of the primary reasons for the movement of rating
agencies into ERM is that they believe companies with an enterprise-wide view of
risks, such as that offered by ERM, are better managed. Several have also noted
that ERM provides an objective view of hard-to-measure aspects such as management capabilities, strategic rigor, and ability to manage in changing circumstances.
He explains that the view of S&P is that positive or negative changes in ERM
14
Overview
programs are considered as leading indicators that show up long before they
could be seen in a company’s published financial data. This chapter provides a
sound base for understanding the background and role of rating agencies in ERM,
a story that is likely still evolving.
“Enterprise Risk Management: Current Initiatives and Issues” (Chapter 26),
contains a roundtable discussion sponsored and published by the Journal of Applied Finance, which includes an expert group of academics and practitioners in the
area of risk management. The discussants consisted of Bruce Branson (Associate
Director of the Enterprise Risk Management Initiative and Professor in the Department of Accounting at North Carolina State University), Pat Concessi (Partner
in Global Energy Markets with Deloitte and Touche, Toronto, Canada), John R.S.
Fraser (Chief Risk Officer and Vice President of Internal Audit at Hydro One Inc.
in Toronto), Michael Hofmann (Vice President and Chief Risk Officer at Koch Industries, Inc. in Wichita, Kansas), Robert (Bob) Kolb (Frank W. Considine Chair in
Applied Ethics at Loyola University Chicago), Todd Perkins (Director of Enterprise
Risk at Southern Company, Inc. in Atlanta, Georgia), Joe Rizzi (Senior Investment
Strategist at CapGen Financial in New York, but at the time of the roundtable discussion, he was the Managing Director of Enterprise Risk Management at Bank of
America and La Salle Bank in Chicago, Illinois), and the moderator Betty J. Simkins
(Williams Companies Professor of Business and Associate Professor of Finance in
the Spears School of Business at Oklahoma State University). This roundtable explored many avenues, concerns, and possible solutions in this evolving arena of
risk management.
Demir Yener, Senior Advisor at Deloitte Consulting, Emerging Markets (Washington D.C.), discusses enterprise risk management applications suitable for, and as
they exist in, a number of emerging market corporations in Chapter 27, “Establishing ERM Systems in Emerging Countries.” He notes that there is a growing interest
in improving corporate governance practices in emerging markets. Following the
financial crises in the Far East and Russia, which impacted many other emerging
markets in 1997–1998, there was a realization that corporate governance practices
had to be improved along with the financial sector infrastructure. The Financial
Stability Forum was convened, as a result of which the OECD (Organisation for
Economic Co-operation and Development) Principles of Corporate Governance
were developed in 1999. Since then the principles have been revised in 2004, and
other standards of business conduct had been introduced to provide guidance in
a number of critical areas of global cooperation for business and finance among
nations. The emerging countries in Demir’s sample include Egypt, Jordan, Mongolia, Serbia, Turkey, and Ukraine. The ERM concept is still a new concept in these
countries and it is likely to take a while to get the emerging country firms, given the
legal and regulatory requirements, to reach the desirable level of risk management
practices.
In Chapter 28, “The Rise and Evolution of the Chief Risk Officer: Enterprise
Risk Management at Hydro One,” Tom Aabo (Associate Professor, Aarhus School
of Business, Denmark), John R.S. Fraser (Chief Risk Officer, Hydro One Inc.), and
Betty J. Simkins (Williams Companies Professor of Business, Oklahoma State University) describe the successful implementation of enterprise risk management
(ERM) at Hydro One Inc. over a five-year period. This chapter was first published
in the Journal of Applied Corporate Finance. Hydro One is a Canadian electric utility
ENTERPRISE RISK MANAGEMENT
15
company that has experienced significant changes in its industry and business.
Hydro One has been at the forefront of ERM for many years, especially in utilizing
a holistic approach to managing risks, and provides a best practices case study for
other firms to follow. This chapter describes the process of implementation beginning with the creation of the chief risk officer position, the deployment of a pilot
workshop, and the various tools and techniques critical to ERM (e.g., the Delphi
Method, risk trends, risk maps, risk tolerances, risk profiles, and risk rankings).
As this brief overview indicates, the chapters in this book present an impressive
coverage of crucial issues on enterprise risk management and are written by leading
ERM experts globally. We believe that no other book on the market provides such
a wide coverage of timely topics—such as ERM management, culture and control,
ERM tools and techniques, types of risk from a holistic viewpoint, leading case
studies, practitioner survey evidence, and academic research on ERM. The authors
of these chapters and we, the editors, invite reader comments and suggestions.
FUTURE OF ERM AND UNRESOLVED ISSUES
As is generally recognized, ERM is still evolving with new techniques and research
of best practices being studied and documented on almost a daily basis. Some of
the issues that we feel deserve the attention of our readers and those interested in
the future of ERM include:
r Why have some companies succeeded and others failed in the implementar
r
r
r
tion of ERM?
What do we predict for the future of ERM?
What research issues remain?
A comment on universities’ ERM programs and education.
What unresolved issues do we see?
The above issues all merit study and more attention than they have received to
date. An entire chapter, if not book, could be written on the reasons for failure in the
implementation of ERM. Often it appears to be caused in part by confusion over
exactly what ERM is and undue expectations of management. Our observation is
that too often the skills and techniques are not available and without support from
the most senior ranks, ERM is destined to fail.
We expect ERM to continue to grow until, in looking back, future managers will
ask “How could you have managed without these basic techniques?” Obviously
there has to be more discussion and clarification on what ERM is and what it has
to offer. While regulatory interest can force ERM into companies, if not done well,
it can become another box-ticking exercise that adds little value.
As highlighted in Chapter 23, the opportunities to study ERM and assist in
moving this new methodology forward are limitless and likely to continue. While
some analysis can be done based on public information, it will require proactive
visionary academics to go into the real world and study what is evolving in real
business practices. This is a veritable goldmine for some intrepid academics and a
minefield for the more timid.
16
Overview
NOTES
1. The Joint Australian/New Zealand Standard for Risk Management (AS/NSZ 4360: 2004),
first edition published in 1995, is the first guide on enterprise risk management that provides practical information. This publication covers the establishment and implementation of the enterprise risk management process.
2. The Committee of Sponsoring Organizations of the Treadway Commission (COSO)
(September 1992 and September 2004).
3. Group of Thirty, Derivatives: Practices and Principles (Washington, DC: 1993).
4. CoCo (Criteria of Control Board of the Canadian Institute of Chartered Accountants).
5. “Where Were the Directors”—Guidelines for Improved Corporate Governance in
Canada, report of the Toronto Stock Exchange Committee on Corporate Governance
in Canada (December 1994).
6. Committee on the Financial Aspects of Corporate Governance (Cadbury Committee,
final report and Code of Best Practices issued December 1, 2002).
7. NYSE Corporate Governance Rules 7C(iii)(D) www.nyse.com/pdfs/finalcorpgovrules
.pdf and Emerging Governance Practices in Enterprise Risk Management, the Conference
Board (2007).
8. McKinsey & Company and Institutional Investor, 1996. “Corporate Boards: New Strategies for Adding Value at the Top.”
9. Risk management in general has been shown to increase firm value. See Smithson,
Charles W., and Betty J. Simkins, “Does Risk Management Add Value? A Survey of the
Evidence,” Journal of Applied Corporate Finance vol. 17, no. 3 (2005): 8–17.
ABOUT THE EDITORS
John Fraser is the Vice President, Internal Audit & Chief Risk Officer of Hydro
One Networks Inc., one of North America’s largest electricity transmission and
distribution companies. He is an Ontario and Canadian Chartered Accountant, a
Fellow of the Association of Chartered Certified Accountants (U.K.), a Certified
Internal Auditor, and a Certified Information Systems Auditor. He has more than
30 years experience in the risk and control field mostly in the financial services
sector, including areas such as finance, fraud, derivatives, safety, environmental,
computers, and operations. He is currently Chair of the Advisory Committee of
the Conference Board of Canada’s Strategic Risk Council, a Practitioner Associate
Editor of the Journal of Applied Finance, and a past member of the Risk Management
and Governance Board of the Canadian Institute of Chartered Accountants. He
is a recognized authority on enterprise risk management and has co-authored three
academic papers on ERM—published in the Journal of Applied Corporate Finance and
the Journal of Applied Finance.
Betty J. Simkins is Williams Companies Professor of Business and Professor of
Finance at Oklahoma State University (OSU). She received her BS in Chemical
Engineering from the University of Arkansas, her MBA from OSU, and her PhD
from Case Western Reserve University. Betty is also active in the finance profession and currently serves as Vice-Chairman of the Trustees (previously President)
of the Eastern Finance Association, on the board of directors for the Financial
Management Association (FMA), as co-editor of the Journal of Applied Finance,
ENTERPRISE RISK MANAGEMENT
17
and as Executive Editor of FMA Online (the online journal for the FMA). She
has coauthored more than 30 journal articles in publications including the Journal
of Finance, Financial Management, Financial Review, Journal of International Business
Studies, Journal of Futures Markets, Journal of Applied Corporate Finance, and the Journal of Financial Research and has won a number of best paper awards at academic
conferences.
CHAPTER 2
A Brief History of
Risk Management
H. FELIX KLOMAN
President, Seawrack Press Inc.
INTRODUCTION
What is risk management (and its alternative title “enterprise risk management”)?
When and where did we begin applying its precepts? Who were the first to use it?
This is a brief and highly personal study of this discipline’s past and present. It is
a description of some of its emotional and intellectual roots. It spans the millennia
of human history and concludes with a detailed list of contributions in the past
century.
RISK MANAGEMENT IN ANTIQUITY
Making good decisions in the face of uncertainty and risk probably began during
the earliest human existence. Evolution favored those human creatures able to
use their experience and minds to reduce the uncertainty of food, warmth, and
protection. Homo sapiens survived by developing “an expression of an instinctive
and constant drive for defense of an organism against the risks that are part of
the uncertainty of existence.”1 This “genetic expression” can be construed as the
beginning of risk management, a discipline for dealing with uncertainty.
As the millennia passed, our species developed other mechanisms for coping
with each day’s constant surprises. We invented a pantheon of divine creatures
to blame for misfortune, praise for good luck, and to whom we offered sacrifices
to mitigate the worst. These gods and goddesses, the personification of heavenly
bodies, high mountains, and the deepest seas, led to a dependence on human oracles, soothsayers, priests, priestesses, and astrologers, to predict the future. We
created a written language (Mesopotamia, Sumeria, Egypt, Phoenicia) in order to
pass knowledge to the future. As our species used language, experience, memory, and deduction to explain random uncertainty, we created an alternative and
backup explanatory system.
The classical world of the Greeks and Romans demonstrates the development
of written language, providing a significant advantage over oral recitation. At
first, Greek memories passed on information from the past. Their written language
19
20
Overview
extrapolated it into more rational predictions. Homer, capturing memory, sang of
Zeus, Hera, Athena, Apollo, and the corps of divinities responsible for the victory
at Troy as well as the misadventures of Odysseus on his return home. But by 585 BC,
the Greek philosopher Thales used his observations, written data, and deductions
to predict an eclipse of the sun, even though he continued to profess a belief in these
gods.2 A century later Herodotus used intelligent “enquiry” to write “history,” but
he too persisted with the power of divinities. It was finally Thucydides, in the early
400s BC, who proposed a “new penetrating realism,” one that “removed the gods
as explanations of the course of events.” Thucydides was “fascinated by the gap
between expectation and outcome, intention and event.”3 Perhaps he should be
called the father of risk management.
A few philosophers in classical Greece tried to emphasize observation, deduction, and prediction, but they inevitably collided with the inertia of belief in
the long-standing system of divine intervention as the explanation for misfortune
as well as good luck. With the growth and dominance of the new monotheistic
religions in the Middle East and Mediterranean, it would take another millennium
before the ideas Thucydides first advanced grew into the solid body of scientific
knowledge to replace myth and superstition.
AFTER THE MIDDLE AGES
Jump ahead another 1,000 years to the emergence of the Renaissance and Enlightenment. Two changes encouraged the idea that we could actually think intelligently
about the future. Peter Bernstein described the first, in his Against the Gods: “The
idea of risk management emerges only when people believe they are to some degree free agents.”4 The second was our growing fascination with numbers. Our
increasing disenchantment with the explanation that a “superior power” ordained
everything became coupled with the capability of manipulating experience and
data into numbers and thence probabilities. We could predict alternative futures!
Peter Bernstein’s book is a joyful and often lyrical exploration of development of
the concept of risk as both threat and opportunity. We became capable of “scrutinizing the past” to suggest future possibilities. He describes those men who first
advanced the ideas of probability measurement, introducing us to familiar and
unfamiliar names from the Renaissance onward:
Leonardo Pisano (who introduced Arabic numerals)
Luca Paccioli (double-entry bookkeeping)
Girolamo Cardano (measuring the probability of dice)
Blaise Pascal (“fear of harm ought to be proportional not merely to the gravity
of the harm, but also to the probability of the event”)
John Graunt (who calculated statistical tables)
Daniel Bernoulli (the concept of utility)
Jacob Bernoulli (the “law of large numbers”)
Abraham de Moivre (the “bell” curve and standard deviation)
Thomas Bayes (statistical inference)
Francis Galton (regression to the mean)
Jeremy Bentham (the law of supply and demand)
A BRIEF HISTORY OF RISK MANAGEMENT
21
Today’s risk management rests, for better or for worse, on these and other
fascinating characters.
Where once philosophers and theologians attributed fortune or misfortune
to the whims of gods, the efforts of those early thinkers described in Bernstein’s
book, “have transformed the perception of risk from chance of loss into opportunity
for gain, from FATE and ORIGINAL DESIGN to sophisticated, probability-based
forecasts of the future, and from helplessness to choice.”5
Bernstein contrasts the development of more rigorous quantitative approaches
to probabilities with recent attempts to understand why “people yield to inconsistencies, myopia, and other forms of distortion throughout the process of decisionmaking.” His story of risk and risk management is one of rationality and human
nature, fighting with each other and then cooperating, to provide a better understanding of uncertainty and how to deal with it. “. . . Any decision relating to risk
involves two distinct yet inseparable elements: the objective facts and a subjective
view about the desirability of what is to be gained, or lost, by the decision. Both
objective measurement and subjective degrees of belief are essential; neither is
sufficient by itself.”
“The essence of risk management,” Bernstein concludes, “lies in maximizing
the areas where we have some control over the outcome while minimizing the areas
where we have absolutely no control over the outcome and the linkage between
effect and cause is hidden from us.”
THE PAST 100 YEARS
Experience and new information allowed us to think intelligently about the future
and plan for potential unexpected outcomes. Many millennia contributed to our
growing ability to distill and use information, but the developments since 1900 are
more apparent and useful. Here is a synopsis of these critical events.
The twentieth century began with euphoria, new wealth, relative peace, and
industrialization, only to descend into chaotic regional and worldwide wars. These
and other catastrophes crushed illusions about the perfectibility of society and
our species, leaving us less idealistic and more appreciative of the continuing
uncertainty of our future.
Ideas drove change in this century. Stephen Lagerfeld cogently summed it up:6
“Apart from the almost accidental tragedy of World War I, the great clashings of
our bloody century have not been provoked by the hunger for land, or riches,
or other traditional sources of national desire, but by ideas—about the value of
individual dignity and freedom, about the proper organization of society, and
ultimately about the possibility of human perfection.”
Risk management is one of those ideas that a logical, consistent, and disciplined approach to the future’s uncertainties will allow us to live more prudently
and productively, avoiding unnecessary waste of resources. It goes beyond faith
and luck, the former twin pillars of managing the future, before we learned to
measure probability. As Peter Bernstein wrote, “If everything is a matter of luck,
risk management is a meaningless exercise. Invoking luck obscures truth, because
it separates an event from its cause.”7
If risk management is an extension of human nature, I should list the most
notable political, economic, military, scientific, and technological events of the past
22
Overview
100 years. The major wars (from the Russo-Japanese, World Wars I and II, Korea,
the Balkan, the first Gulf War and Iraq, to the numerous regional conflicts) and
the advent of the automobile, radio, television, computer and Internet, the Great
Depression, global warming, the atom bomb and nuclear power, the rise and fall
of communism, housing, the dot-com, derivative, and lending bubbles, and the
entire environmental movement affected the development of risk management.
Major catastrophes did so more directly: the Titanic (the “unsinkable” ship sinks),
the Triangle Shirtwaist fire (the failure to allow sufficient exits), Minimata Bay (mercury poisoning in Japan), Seveso (chemical poisoning of the community in Italy),
Bhopal (chemical poisoning in India), Chernobyl (Russian nuclear meltdown),
Three Mile Island (potential U.S. nuclear disaster that was contained), Challenger
(U.S. space shuttle break up), Piper Alpha (North Sea oil production platform explosion and fire), Exxon Valdez (Alaskan ship grounding and oil contamination),
to cite some of the more obvious. Earthquakes, tsunamis, typhoons, cyclones, and
hurricanes continue to devastate populous regions, and their increasing frequency
and severity stimulate new studies on causes, effects, and prediction, all part of
the evolution of risk management.
The most significant milestones, in my opinion, are more personal: the new
ideas, books, and actions of individuals and their groups all of whom stimulated the
discipline. Here’s my list:
1914 Credit and lending officers in the United States create Robert Morris Associates in Philadelphia. By 2000 it changes its name to the Risk Management
Association and continues to focus on credit risk in financial institutions.
In 2008 it counted 3,000 institutional and 36,000 associate members.8
1915 Friedrich Leitner publishes Die Unternehmensrisiken in Berlin (Enzelwirt.
Abhan. Heft 3), a dissertation on risk and some of its responses, including
insurance.
1921 Frank Knight publishes Risk, Uncertainty and Profit, a book that becomes
a keystone in the risk management library. Knight separates uncertainty,
which is not measurable, from risk, which is. He celebrates the prevalence
of “surprise” and he cautions against over-reliance on extrapolating past
frequencies into the future.9
1921 A Treatise on Probability, by John Maynard Keynes, appears. He too scorns
dependence on the “Law of Great Numbers,” emphasizing the importance
of relative perception and judgment when determining probabilities.10
1928 John von Neumann presents his first paper on a theory of games and strategy at the University of Göttingen, “Zur Theorie der Gesellschaftsspiele,”
Mathematische Annalen, suggesting that the goal of not losing may be superior to that of winning. Later, in 1944, he and Oskar Morgenstern publish
The Theory of Games and Economic Behavior (Princeton University Press,
Princeton, NJ).
The U.S. Congress passes the Glass-Steagall Act, prohibiting common
ownership of banks, investment banks, and insurance companies. This Act,
finally revoked in late 1999, arguably acted as a brake on the development
of financial institutions in the United States and led the risk management
discipline in many ways to be more fragmented than integrated. The financial disasters after 2000 cause some to question the wisdom of revocation.
A BRIEF HISTORY OF RISK MANAGEMENT
23
1945 Congress passes the McCarran-Ferguson Act, delegating the regulation
of insurance to the various states, rather than to the federal government,
even as business became more national and international. This was another
needless brake on risk management, as it hamstrung the ability of the
insurance industry to become more responsive to the broader risks of its
commercial customers.
1952 The Journal of Finance (No. 7–, 77–91) publishes “Portfolio Selection,” by
Dr. Harry Markowitz, who later wins the Nobel Prize in 1990. It explores
aspects of return and variance in an investment portfolio, leading to many
of the sophisticated measures of financial risk in use today.11
1956 The Harvard Business Review publishes “Risk Management: A New Phase
of Cost Control,” by Russell Gallagher, then the insurance manager of
Philco Corporation in Philadelphia. This city is the focal point for new “risk
management” thinking, from Dr. Wayne Snider, then of the University of
Pennsylvania, who suggested in November 1955 that “the professional
insurance manager should be a risk manager,” to Dr. Herbert Denenberg,
another University of Pennsylvania professor who began exploring the
idea of risk management using some early writings of Henri Fayol.
1962 In Toronto, Douglas Barlow, the insurance risk manager at Massey
Ferguson, develops the idea of “cost-of-risk,” comparing the sum of selffunded losses, insurance premiums, loss control costs, and administrative
costs to revenues, assets, and equity. This moves insurance risk management thinking away from insurance, but it still fails to cover all forms of
financial and political risk.
That same year Rachel Carson’s The Silent Spring challenges the public
to consider seriously the degradation to our air, water, and ground from
both inadvertent and deliberate pollution. Her work leads directly to the
creation of the Environmental Protection Agency in the United States in
1970, the plethora of today’s environmental regulations, and the global
Green movement so active today.12
1965 The Corvair unmasked! Ralph Nader’s Unsafe at Any Speed appears and
gives birth to the consumer movement, first in the United States and later
moving throughout the world, in which caveat vendor replaces the old
precept of caveat emptor. The ensuing wave of litigation and regulation
leads to stiffer product, occupational safety, and security regulations in
most developed nations. Public outrage at corporate misbehavior also
leads to the rise of litigation and the application of punitive damages in
U.S. courts.13
1966 The Insurance Institute of America develops a set of three examinations
that lead to the designation “Associate in Risk Management” (ARM), the
first such certification. While heavily oriented toward corporate insurance
management, its texts feature a broader risk management concept and are
revised continuously, keeping the ARM curriculum up-to-date.14
1972 Dr. Kenneth Arrow wins the Nobel Memorial Prize in Economic Science,
along with Sir John Hicks. Arrow imagines a perfect world in which every
uncertainty is “insurable,” a world in which the Law of Large Numbers
works without fail. He then points out that our knowledge is always
incomplete—it “comes trailing clouds of vagueness”—and that we are
24
Overview
best prepared for risk by accepting its potential as both a stimulant and
penalty.
1973 In 1971, a group of insurance company executives meet in Paris to create
the International Association for the Study of Insurance Economics. Two
years later, the Geneva Association, its more familiar name, holds its first
Constitutive Assembly and begins linking risk management, insurance,
and economics. Under its first Secretary General and Director, Orio Giarini,
the Geneva Association provides intellectual stimulus for the developing
discipline.15
That same year, Myron Scholes and Fischer Black publish their paper
on option valuation in the Journal of Political Economy and we begin to learn
about derivatives.16
1974 Gustav Hamilton, the risk manager for Sweden’s Statsforetag, creates
a “risk management circle,” graphically describing the interaction of all
elements of the process, from assessment and control to financing and
communication.
1975 In the United States, the American Society of Insurance Management
changes its name to the Risk & Insurance Management Society (RIMS),
acknowledging the shift toward risk management first suggested by
Gallagher, Snider, and Denenberg in Philadelphia 20 years earlier. By 2008,
RIMS has almost 11,000 members and a wide range of educational programs and services aimed primarily at insurance risk managers in North
America. It links with sister associations in many other countries around
the world through IFRIMA, the International Federation of Risk & Insurance Management Associations.17
With the support of RIMS, Fortune magazine publishes a special article
entitled “The Risk Management Revolution.” It suggests the coordination
of formerly unconnected risk management functions within an organization and acceptance by the board of responsibility for preparing an organizational policy and oversight of the function. Twenty years lapse before
many of the ideas in this paper gain general acceptance.
1979 Daniel Kahneman and Amos Tversky publish their “prospect theory,”
demonstrating that human nature can be perversely irrational, especially
in the face of risk, and that the fear of loss often trumps the hope of gain.
Three years later they and Paul Slovic write Judgment Under Uncertainty:
Heuristics and Biases, published by Cambridge University Press. Kahneman
wins the Nobel Prize in Economics in 2002.
1980 Public policy, academic and environmental risk management advocates
form the Society for Risk Analysis (SRA) in Washington. Risk Analysis, its
quarterly journal, appears the same year. By 2008, SRA has more than 2,500
members worldwide and active subgroups in Europe and Japan. Through
its efforts, the terms risk assessment and risk management are familiar in
North American and European legislatures.18
1983 William Ruckelshaus delivers his speech on “Science, Risk and Public
Policy” to the National Academy of Sciences, launching the risk management idea in public policy. Ruckelshaus had been the first director of the
Environmental Protection Agency, from 1970 to 1973, and returned in 1983
to lead EPA into a more principled framework for environmental policy.
Risk management reaches the national political agenda.19
A BRIEF HISTORY OF RISK MANAGEMENT
25
1986 The Institute for Risk Management begins in London. Several years later,
under the guidance of Dr. Gordon Dickson, it begins an international set
of examinations leading to the designation, “Fellow of the Institute of
Risk Management,” the first continuing education program looking at risk
management in all its facets. This program is expanded in 2007–2008 for
its 2,500 members.20
That same year the U.S. Congress passes a revision to the Risk Retention Act of 1982, substantially broadening its application, in light of
an insurance cost and availability crisis. By 1999, some 73 “risk retention
groups,” effectively captive insurance companies under a federal mandate,
account for close to $750 million in premiums.
1987 “Black Monday,” October 19, 1987, hits the U.S. stock market. Its shock
waves are global, reminding all investors of the market’s inherent risk and
volatility.
That same year Dr. Vernon Grose, a physicist, student of systems
methodology, and former member of the National Transportation Safety
Board, publishes Managing Risk: Systematic Loss Prevention for Executives,
a book that remains one of the clearest primers on risk assessment and
management.21
1990 The United Nations Secretariat authorizes the start of IDNDR, the International Decade for Natural Disaster Reduction, a 10-year effort to study
the nature and the effects of natural disasters, particularly on the lessdeveloped areas of the world, and to build a global mitigation effort.
IDNDR concludes in 1999 but continues under a new title, ISDR, the International Strategy for Disaster Reduction. Much of its work is detailed
in Natural Disaster Management, a 319-page synopsis on the nature of hazards, social and community vulnerability, risk assessment, forecasting,
emergency management, prevention, science, communication, politics,
financial investment, partnerships, and the challenges for the twenty-first
century.22
1992 The Cadbury Committee issues its report in the United Kingdom, suggesting that governing boards are responsible for setting risk management
policy, assuring that the organization understands all its risks, and accepting oversight for the entire process. Its successor committees (Hempel and
Turnbull), and similar work in Canada, the United States, South Africa,
Germany, and France, establish a new and broader mandate for organizational risk management.23
In 1992, British Petroleum turns conventional insurance risk financing
topsy-turvy with its decision, based on an academic study by Neil Doherty
of the University of Pennsylvania and Clifford Smith of the University of
Rochester, to dispense with any commercial insurance on its operations in
excess of $10 million. Other large, diversified, transnational corporations
immediately study the BP approach.24
The Bank for International Settlements issues its Basel I Accord to help
financial institutions measure their credit and market risks and set capital
accordingly.
The title “Chief Risk Officer” is first used by James Lam at GE
Capital to describe a function to manage “all aspects of risk,” including risk management, back-office operations, and business and financial
planning.
26
Overview
1994 Bankers Trust, in New York, publishes a paper by its CEO, Charles
Sanford, entitled “The Risk Management Revolution,” from a lecture at
MIT. It identifies the discipline as a keystone for financial institution
management.25
1995 A multidisciplinary task force of Standards Australia and Standards
New Zealand publishes the first Risk Management Standard, AS/NZS
4360:1995 (since revised in 1999 and 2004), bringing together for the first
time several of the different subdisciplines. This standard is followed by
similar efforts in Canada, Japan, and the United Kingdom. While some
observers think the effort premature, because of the constantly evolving
nature of risk management, most hail it as an important first step toward
a common global frame of reference.26
That same year Nick Leeson, a trader for Barings Bank, operating
in Singapore, finds himself disastrously overextended and manages to
topple the bank. This unfortunate event, a combination of greed, hubris,
and inexcusable control failures, receives world headlines and becomes
the “poster child” for fresh interest in operational risk management.
1996 The Global Association of Risk Professionals (GARP), representing credit,
currency, interest rate, and investment risk managers, starts in New York
and London. By 2008, it has more than 74,000 members, plus an extensive
global certification examination program.27
Risk and risk management make the best-seller lists in North America and Europe with the publication of Peter Bernstein’s Against the Gods:
The Remarkable Story of Risk. Bernstein’s book, while first a history of the
development of the idea of risk and its management, is also, and perhaps
more importantly, a warning about the overreliance on quantification:
“The mathematically driven apparatus of modern risk management contains the seeds of a dehumanizing and self-destructive technology.”28 He
makes a similar warning about the replacement of “old-world superstitions” with a “dangerous reliance on numbers,” in “The New Religion of
Risk Management,” in the March–April 1996 issue of The Harvard Business
Review.
1998 The collapse of Long-Term Capital Management, a four-year-old hedge
fund, in Greenwich, Connecticut, and its bailout by the Federal Reserve,
illustrate the failure of overreliance on supposedly sophisticated financial
models.
2000 The widely heralded Y2K bug fails to materialize, in large measure because of billions spent to update software systems. It is considered a success
for risk management.
The terrorism of September 11, 2001, and the collapse of Enron remind the world that nothing is too big for collapse. These catastrophes
reinvigorate risk management.
PRMIA, the Professional Risk Manager’s International Association,
starts in the United States and United Kingdom. By 2008, it counts 2,500
paid and 48,000 associate members. It, too, sponsors a global certification
examination program.29
In July, the U.S. Congress passes the Sarbanes-Oxley Act, in response
to the Enron collapse and other financial scandals, to apply to all public
A BRIEF HISTORY OF RISK MANAGEMENT
27
companies. It is an impetus to combine risk management with governance
and regulatory compliance. Opinion is mixed on this change. Some see this
combination as a step backward, emphasizing only the negative side of
risk, while others consider it a stimulus for risk management at the board
level.
2004 The Basel Committee on Banking Supervision publishes the Basel II Accords, extending its global capital guidelines into operational risk (Basel I
covered credit and market risks). Some observers argue that while worldwide adoption of these guidelines may reduce individual financial institution risk, it may increase systemic risk. These global accords may lead
to similar guidelines for nonfinancial organizations.30
2005 The International Organization for Standardization creates an international working group to write a new global “guideline” for the definition,
application, and practice of risk management, with a target date of 2009
for approval and publication.31
2007 Nassim Nicolas Taleb’s The Black Swan is published by Random House in
New York. It is a warning that “our world is dominated by the extreme, the
unknown, and the very improbable . . . while we spend our time engaged
in small talk, focusing on the known and the repeated.”32 Taleb’s 2001
book, Fooled by Randomness (Textere, New York) was an earlier paean to
the importance of skepticism on models.
2008 The United States Federal Reserve bailout of Bear Stearns appears to
many to be an admission of the failure of conventional risk management
in financial institutions.
Perhaps Peter Bernstein’s Against the Gods is a fitting end to this list of risk management milestones. It illustrates the importance of communication. Too often, new
ideas have been unnecessarily restricted to the cognoscenti. Arcane mathematics,
academic prose, and the secretiveness of current risk management “guilds,” each
protecting their own turf, discourage needed interdisciplinary discussion. Peter’s
lucid prose, compelling syntheses of difficult concepts, personal portraits of creative people, and particularly his warnings of the perils of excess quantification,
bring us an appreciation of both the potential and perils of risk management. No
matter what title we attach to this thinking process (risk management; enterprise
risk management; strategic risk management; etc.), it will continue to be a part of
the human experience.
None of this retrospection has any meaning or value unless it acts as a stimulant
for a more prudent, intelligent, and optimistic use of the ideas and tools of past
innovators.
Step out and create some new risk milestones.
Paradoxically, the very mortality that bears each of us along to a finite conclusion also
gives us, through its unfolding, the means to repossess what we believe we have lost. It is
in memory, given its true shape through the imagination, that we can truly possess our
lives, if we will only strive to regain them.
—Louis D. Rubin Jr., Small Craft Advisory
Atlantic Monthly Press, New York, 1991
28
Overview
Risk and time are opposite sides of the same coin, for if there were no tomorrow there would
be no risk. Time transforms risk, and the nature of risk is shaped by the time horizon: the
future is the playing field.
—Peter Bernstein, Against the Gods, John Wiley & Sons, New York, 1996
(Revision September 2008. An earlier version of this brief history
appeared in the December 1999 issue of Risk Management Reports.)
NOTES
1. Douglas Barlow, in letter to the author, January 8, 1998. Barlow was, for many years, the
risk manager for Canada’s Massey Ferg...
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