ERM only has value to those who know that the future is uncertain.

Businesses have three key needs.

First they need to have a product or service that people will buy. They need revenues.

Second they need to have the ability to provide that product or service at a cost less than what their customers will pay. They need profits.

Once they have revenues and profits, their business is a valuable asset. So third, they need to have a system to avoid losing that asset because of unforeseen adverse experience. They need risk management.

So Risk Management is the third most important need of a firm.

And there is often a conflict between risk management and the other two goals. Risk management will sometimes say that a business activity that produces revenue is too risky and must be curtailed or modified in such a way that it produces less revenues. Risk Management often costs money or otherwise depresses profits. For example, an insurance policy covering fire of a building owned by the firm will cost money and depress profits.

So Risk Management needs to defend its value to the firm. Many risk management proponents have been asked to tell the value added of their activities. This is difficult to explain. Not because risk management does not have a value, but because the cost of risk management in terms of reduced revenues or increased costs are usually tangible and definite, while the benefits are probabilistic. Often the person asking the question is looking for a traditional spreadsheet answer that shows two columns adding up and perhaps the difference between the two is the benefit of risk management.

It does not work that way. For Risk Management to have value, one must understand that the future is uncertain. The value of risk management comes from the way that it shapes that uncertainty.

The next time you are asked about the value of risk management, ask the questioner what value they would put on the airbags and seat belts in their car. If they have no uncertainty about their ability to avoid accidents, then they will put a zero value on the safety devices – the personal risk management systems. If they resist answering, ask them if they will agree to have them removed for $20? Or for $2000? What value do they place on that risk management?

Most people will agree that the demise of a company is less serious than the demise of a person, but it is not difficult to see that there is some value to activities that increase the chance that a company will not expire in the next business cycle or windstorm.

So risk management decreases the uncertainty about the survival of the firm. There is a way to quantitatively value that reduction in uncertainty and compare it to the reduced revenues or increased costs of the risk management activities.

Explore posts in the same categories: ERM, Hedging, Profits, Reinsurance, Revenues, Risk Management, risk transfer, Uncertainty

Tags: Enterprise Risk Management

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