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ACHIEVING KPIs THROUGH RISK MANAGEMENT. : THE CHALLENGES AHEAD. (I) INTRODUCTION. WHAT IS ENTERPRISE RISK MANAGEMENT (ERM) ? Holistic, proactive approach that identify and measure all of the enterprise’s risk exposures and manage them within a unified framework;
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ACHIEVING KPIs THROUGH RISK MANAGEMENT : THE CHALLENGES AHEAD
(I) INTRODUCTION WHAT IS ENTERPRISE RISK MANAGEMENT (ERM) ? • Holistic, proactive approach that identify and measure all of the enterprise’s risk exposures and manage them within a unified framework; • A fundamental shift in the way business must approach risk;
Growing interest in ERM in recent years, more so with heavily publicized cases such as Enron, World Com and the passage of compliance mandate such as the Sarbanes-Oxley Act of 2002, Basel II and industry-wide initiatives; • According to the Committee of Sponsoring Organizations of the Treadway Commision (COSO), ERM deals with risks and opportunities affecting value creation or preservation and is defined as follow:
“Enterprise risk management is 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”
Relationship between ERM and traditional methods of treating risk: • Traditionally risk is being handled through the silo approach; • Corporate losses or those due to pure risk such as property losses, liability suits, workmen compensations and others are being handled through insurance contracts and others;
Financial losses or those due to speculative risk such as credit risk, operational risk, liquidity risk and others are being handled through derivative contracts such as options, swaps, futures or forwards;
In short ERM consist of : Corporate risk management/pure risk Enterprise risk management Total Risk Management + Financial risk management /speculative risk
ERM Consists Of Eight Interrelated Components: • Internal • Objective • Event Identification • Risk Management • Risk Response • Control Activities • Information & Communication • Monitoring
(II) KEY PERFORMANCE INDICATORS (KPIs) KPIs of an organization can be viewed from four perspective namely: • Financial perspective • Customer perspective • Internal Business Process Perspective • Learning and Growth (Human Resource) Perspective
The four perspective will be attachedto the organization as follows: Financial Customer Vision and Strategy Internal Business Process Learning and Growth (HR) (Kaplan & Norton)
Under the different perspective; the objectives and initiatives are: (Paul R. Niven)
(III) ERM’s ROLE IN ACHIEVING KPIs a)Financial Perspectives: • Guaranteeing insofar as possible that an organization will not be prevented from pursuing its other goals as a result of losses associated with pure risks;
It can contribute directly to profit by controlling the cost of risk; since the profit depends on the level relative to income to the extent that ERM activities can reduce expenses they directly increase profits; • ERM can also reduce expenses through risk control measures; if the cost of loss prevention and control measures is less than the amount of losses prevented, the expense of uninsured loss is reduced; loss prevention and control measures could also reduce the cost of insurance;
Since the effect of losses from pure risk can be minimized the organization has greater latitude in the speculative risk activities; there will be inevitable trade-off between pure and speculative risks; by managing the amount of pure risk with which the organization must contend, ERM increases the organization’s ability to engage in speculative risk;
b) Customer Perspective : • By adopting the partner programs, frequent purchase programs the organization will be able to increase customer loyalty and market share; this can be viewed as increasing the number of risk exposures which is in line with the effort to reduce risk;
c) Internal Business Process : • By developing customer profile, the organization would be able to identify the targeted or segmented preferred customers with the least risk possible; • By eliminating defects through a maintenance overhaul program the organization would be able to produce better products which in turn will attract more customers as well as reduce cost eventually;
d) Employee Learning & Growth Perspective : • By conducting more training and other skill enhancing programs, the knowledge and expertise of employees will be increased and this will finally improve quality in the organization, reduce errors and reduce cost of operation.
Apart from the above mentioned KPIs, ERM can be utilized in many other situations such as: • Financial type risks; • Credit risk • Liquidity risk • Interest rate risk • Currency exchange risk
Risks related to Systems; • Issues related to Shareholder Wealth; • Opportunity cost of capital; • Expected cash flow;
(IV) ANALYTICAL TOOL • Among the analysis tools used in corporate risk management are : • Constructing the frequency and severity of losses from historical data; • Constructing the total loss distribution;
Computer simulation of loss distributions; • Regression and correlation analysis; • Use of discounted cash flow analysis; • Other more sophisticated analysis such as multivariate and factor analysis nonparametric statistics and others.
(V) CONCLUSION It is natural for the evolution of enterprise risk management to take place because it would bring together the management of all risks-financial, operational, strategic and traditionally insured hazards – into a single portfolio. The convergence of responsibility for managing pure risks and other risks is a foregone conclusion and that the responsibility
of risk managers should be expanded to include other risks especially those relating to other facets of finance. However, the concepts of enterprise risk management is still relatively new. What remains unclear is who will have ultimate responsibility for managing a company’s enterprise risk portfolio. The disagreement is not about whether financial risks susceptible to treatment by derivatives futures and options should be managed,
but whether they should be managed by the same person who manages the risks of fires, explosions, embezzlements and legal liability.
