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.

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

Tags:

You can comment below, or link to this permanent URL from your own site.

11 Comments on “ERM only has value to those who know that the future is uncertain.”


  1. […] But if we did that, we would be falling into exactly the same trap that makes it almost impossible to keep support for risk management over time.  Risk Management will fail if it becomes about making the right risk “picks”. […]


  2. […] Many firms have set out to create a Risk system on a much, much shorter time frame.  One approach would be to say that since Losses are the opposite of Profits, then assign the responsibility for Security to the same people who have that responsibility for Profits. But what is likely to happen there is that attention to Profits will most often trump attention to Risk.  That is natural, since Profits are higher up the Hierarchy of Corporate Needs than Risk. In addition, measuring Profits is most often done in arrears and Risk can best be managed when measured in advance.  In fact, when responsibility for Risk is given to the folks who are experienced in managing Profits, they often make the mistake of trying to manage Risk by looking backwards. […]


  3. Good points in the post.

    But remember risk is must a negative lottery ticket.

    Imagine you are short on the rent. Do nothing and you are ruined for sure. You can play a classic lottery – bad odds but still a significant chance to win. So you take the risk, choose X% chance of getting by, over certain failure.

    That’s all too often the case in business, and the reason why so many fail to hedge, or insure, or expend the operating efforts to avoid risk.

  4. Boris Says:

    I like the post, especially now when I switched from being a risk manager to be a business owner and now I understand more all 3 major business needs you explained.
    1. – a great product a service
    2. – ability to sell it repeatedly with profits
    3. – a system that will avoid losing the business asset
    I however disagree with your sequence of priorities. Certainly this was true in the industrial age when companies first developed products and then look for the customers. Now I think the ability to understand customer’s needs and constantly develop products based on these needs will make all the difference between successful and a failed company. And risk management should play not only a role of parachute or an air bag system, but also work together to increase revenue side of the business, so it will stay competitive.

    I look forward to seeing your further contribution in the GlobalRisk community


  5. […] ERM retrospectively taking into account only experienced gains and losses.  (see ERM Value)  A good ERM program changes the likelihood of losses, but in any short period of time actual […]


  6. […] ERM only has value to those who know that the Future is Uncertain (August 2009)  Explains how ERM must be valued prospectively, not retrospectively. […]


  7. Great post. At the risk of sounding self-serving, I would assert that Risk Management may be the most important need for a business. A business can exist without profit – e.g. break even. It may not grow, but it can exist indefinitely (small town America is full of examples). And a business can exist without revenue – Twitter is a great example. But can Twitter afford to not have RM?

    Very thought provoking… thanks.

    • riskviews Says:

      Thomas,

      I have to admit that you have an important point there. I am referring to businesses that fit the standard economic model. I agree that there are businesses and other organizations that do not fit the model.

      But I cannot agree that there are any businesses or other organizations whose primary aim is to survive. That is what would be needed for risk management to be the first priority.

      So my wording needs to be adapted to fit these other types of organizations. To make it totally general, all organizations need to have the ability to attract clientele. And they must provide something to that clientele that the organization can do repeatedly over time.

      The terms I used in the post, Revenues and Profits are the way that many businesses measure these two things. Unfortunately, many, many businesses have forgotten that these measures are simply proxies for something more fundamental, just as I forgot.


      • Thank you for your reply, Dave. I apologize if my comment came across as if I am looking for concession or correction. I’m not. I’m just exploring your concept a bit.

        You’re absolutely right in saying there are no orgs whose primary objective is to survive (at least legitimate orgs). And I also agree that all established businesses have financial needs that must be met before their RM needs (even Twitter :-). Your prioritization is sound.

        As I was reading your post, I was thinking in terms of start-ups, where risk management must exist before the other needs come to the forefront. It would seem to be a ‘chicken & the egg’ scenario. RM is critical to business planning and start-up, thus becoming viable is dependent upon RM. However, at some point it transitions to where RM really can’t exist unless the business has some basic viability. Thoughts?

        Great food for thought on a slow Sunday night, Dave. Your post and reply have been very helpful. Thanks.

        Tom

  8. Sanjay Kumar Thakur Says:

    Hi,
    Excellent reading.I used to ask similar analogy- How much would you value the Parachute in the airline, on the value addition issue of the risk manageent. However, I liked your Car Analogy more effective to explain.
    On academic front, there are many studies conducted which empirically studied the value added by the risk management.Few of them are {Titman (2001), Jin and Jorion (2006), Myers and Majluf (1984), Bessembinder (1991), Bauman, and Miller (1994), DeMarzo and Duffie (1995), DeMaskey (1995), Dufey (2003), Adam and Fernando (2006), Guay and Kothari (2003)} which established that risk management adds significant value, thus negating the classic argument of Modigliani and Miller (1958).

    regards,
    Sanjay

  9. riskczar Says:

    Riskczar loves it!

    Great read. I love the seat belt analogy and the 1,2,3 ranking order.

    Trevor Levine
    http://www.riskczar.com


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s


%d bloggers like this: