Three Faces of Risk Management

There is quite a bit of confusion around risk management.  Some of that confusion comes  from the fact that there are three largely different activities out there that are by different groups considered to be Risk Management,  When you read about risk management, you need to somehow guess which of the three versions of risk management the author intends to discuss.  Most folks, including many of the risk management experts, do not even know that they are only talking about one of the three faces of ERM. So here they are:

I.  Loss Controlling – this aspect of ERM focuses on minimizing losses.  It is the more traditional type of risk management and is the main type of ERM that is practices outside of the financial sector.

II.  Risk Trading – is the focus of ERM for banks that buy and sell risks and for insurers who sell their risk aggregation capabilities.  THe main focus of risk trading is the pricing of risks.  Complex models are usually used to do the pricing and evaluation of risks.

III.  Risk Steering – is the practice of looking at broad risk choices for a firm the same way that a portfolio manager does strategic asset allocation. This aspect of ERM is very popular in theory, but in fact, there are very few firms that are really doing this.

No wonder there is confusion.  These things seem to be almost totally different topics.

Materials from banks that make up the vast majority of the words about risk management talks almost solely about risk trading.  In a bank risk trading operation, the main important thing is to keep track of the fluctuations in market prices.  Anyone from outside of banking is easily frustrated by reading this literature since it does not seem to apply.  The holy grail of financial economics enthusiasts was to securitize and trade all risks so that they all could be managed using the risk trading techniques.  The atomization of risk allowed by these techniques was believed to have drastically reduced the overall risk of the system.  (Events of the financial crisis seem to disprove the notion that atomizing a risk reduces the amount of risk in any way – it seems to have turned concentrated risks into systemic risks – not exactly a good result.)

Insurers also live primarily in a risk trading world, but in a very different risk trading world from the banks.  That is because insurers turnover period for its risks is much, much longer than the banks.  Banks think of their trading risks as having a turnover period of one month or less.  Insurers holding period is measured in years or even decades.  Unfortunately the bank led focus on very short term movements in market values is being applied to insurance for both accounting and solvency assessment.  There are many possible consequences of this very short term focus on risks with long term holding periods.  A few of them are good, making insurers attend to the messages that the market sends through price changes is the primary benefit.  But there will doubtless be many unintended consequences, and some of them will be adverse.  Considering how poorly this system has worked for banks the severity might be extreme.

And then there are the other 90%+ of the businesses in the world.  They do not generally trade their risks either and for the most part do not even have tradable risks.  Risk Trading and the entire ERM system built up for risk trading does not apply to them.

The non-financial firm risk managers who try to read the literature from the financial sector come away thinking that ERM is just not for them at all.  But that is because of the trading orientation of that literature.

Loss controlling is the historical version of ERM that perhaps banks will start to re-emphasize after the massive losses from the risk trading system.  Loss controlling is the process of evaluating risks (underwriting for credit and insurance risks) and limiting total exposures and concentrations of risk.

Loss controlling is the where the action is for non-financial firms.  But every indication is that business schools teach about risk management solely in terms of risk trading.  All of this adds to the feeling that is common among non-financial firm management that ERM is just not for them.

The third area of Risk managment, Risk Steering is named that way to evoke the idea of steering a super-tanker.  Risk Steering involves evaluating and changing the risk profile of the firm at a macro level.  Risk Steering is a macro version of Risk Trading, but it does not in any way require any of the detailed market based analysis that is used for risk trading.

Many firms have tried to use risk steering models for risk trading or risk trading models for steering.  Speed boats and supertankers cannot be interchanged.

Risk Steering involves bringing the consideration of risk and the firms risk profile into the strategic decision making process.  It requires a broad and high level understanding of the firm’s risks – the degree to which they diversify each other and the degree to which they are concentrated.  Major decisions, such as acquisitions are examined in the light of the risk profile and change in risk profile that they entail.  Businesses with high risk are regularly examined to verify that the firm continues to want all of the risk created.  Businesses that produce high returns are examined to determine whether  the high return is the result of some risk that was not accounted for.

So next time you read about risk management, ask yourself which of these three types of risk management the author is referring to.

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Explore posts in the same categories: Enterprise Risk Management, ERM, Risk, risk assessment, Risk Management

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