Enterprise Risk Management – Small Businesses

1. Enterprise Risk Management – Small Businesses 2012 SOA Annual Meeting Session 21 Jay Vadiveloo, Towers Watson Dr. H.G. Parsa, University of Denver

2. Outline Motivation for Enterprise Risk Management for Small Businesses (ERM-SB) initiative Why ERM-SB does not exist? Similarities and differences between ERM for large corporations and small businesses ERMSB initiative at the Goldenson Center, Univ. of Connecticut Case study – ERM analysis of the Restaurant Industry Where do we go from here? Conclusion 2

3. Motivation for ERM-SB Initiative • Small businesses are the largest, fastest growing and most important segment of the American economy • Small businesses experience one of the highest failure rates compared to large corporations • Lack of any institutional or formalized risk management for small businesses • Small businesses do not practice risk management in a formalized or organized manner. • Enterprise Risk Management is a comprehensive approach addressing risk in all functional areas • ERM is an effective proactive prevention tool for small businesses

4. Why ERM is not popular with Small Businesses? • Small Businesses do not use ERM frequently for • Lack of familiarity • Cost of implementation • Fear of change • May be financially unable to do so • Unaware of benefits of ERM • ERM as a prevention tool • ERM as an early ‘wake up’ call • ERM as a comparative analysis tool • ERM as a financial tool As a consequence, ERM principles and literature are tailored primarily to large corporations

5. ERM for Large Corporations Vs. Small Businesses • Fundamental Steps are Similar • Identify and prioritize risks • Model and quantify the risks • Customize the model for the industry / firm • Create risk-mitigation strategies • ERM as an ‘exercise regime’ for healthy operation of a small business • ERM reduces insurance costs • ERM lowers workman compensation costs • ERM lowers potential risk in financial matters • ERM helps in identifying operational risks and the associated costs

6. Differences with ERM for Large Corporations • Needs to incorporate business growth strategies as well • Need to focus on reasonably likely risks with serious consequences versus low likelihood events with serious consequences • Business owners are very knowledgeable about risks and business growth strategies • Easier to assess and manage risks of a small business, but consequences of a risk shock are far greater • Qualitative Risks Vs. Quantitative Risks • ERM analysis covers shorter time periods (one to three years) and should be revisited periodically to remain relevant

7. Differences with ERM for Large Corporations: continued A well defined ERM analysis, which incorporates business growth strategies, can materially improve the sustainability and profitability of a small business

8. ERM Initiative at the Goldenson Center, Univ. of Connecticut • Successfully operating for the past three years • Numerous success stories of helping small businesses with ERM • Students are funded by the Goldenson Center to undertake ERM-SB projects in the region • Service offered free-of-charge to small businesses • Students work in teams and provide a formal written ERM report and any software tools at the end of each project • It is a win-win situation • Small scale operations are in progress and on-going • Restaurant industry is the ideal choice for testing ERM-SB model,

9. Enterprise Risk Management – Restaurant Industry

10. ERM IN SMALL Businesses • Service Economy • Restaurants as a Case Study • One of the largest service industries in US • Over $640 Billion in annual sales • Nearly 13 million employed in this industry • Americans eat 1 in 3 meals at restaurants • A classic small business industry

11. ERM IN SMALL Businesses • Failure Rate in Restaurants • Over 30% of restaurants fail in the first year • Nearly 60% fail in 3 years • Survival rate dramatically increases after the 5th year • Independents have higher failure rate than chain restaurants • Failure rate depends on various factors

12. ERM IN SMALL Businesses Factors in Restaurant Failure: • Macro Factors • Economy, Legislation, Tourism, Food Trends, Technology, Demographic Shifts • Micro Factors • Prime Costs, Management, Working Capital, Quality of Life, Entrepreneurial Incompetence, Control Systems, Cash Flow Mgmt.

13. ERM IN SMALL Businesses • Factors in Restaurant Failure: • Size of a Restaurant: Small vs Large • Ownership: Franchised Vs Non-Franchised • Concept: Regional preferences • Location: Downtowns Vs Suburbs • Location: Zip Codes

14. ERM IN SMALL Businesses • Factors in Restaurant Failure: 6. Demographics – Study from Boulder, CO 7. Working Capital Vs Investment Capital 8. Cost Structure – Prime Costs 9. Economy – Tourism in particular 10. Legislation – National, Regional and Local 11. Legislation – Calories – Study from Denver Univ.

15. ERM IN SMALL Businesses • Restaurant Failure Studies – • Columbus, Oh - Ohio State University • Atlanta, GA • Los Angeles, CA • Boulder, CO • Case Studies – Cornell University Report

16. ERM IN SMALL Businesses Risk Metrics and ERM in Restaurants • Financial Metrics • Operational Metrics

17. ERM IN SMALL Businesses Financial Risk Metrics in Restaurants • Sales per Unit • Sales Growth in Dollars per Unit • Sales Growth Rate over 1, 3, 5 years • Ratio of Food to Beverage Sales • Prime Cost (Food / Labor Cost)

18. ERM IN SMALL Businesses Financial Risk Metrics in Restaurants • Gross Margin • IBITAD • Cash Flow Analysis • Debt to Income Ratio • Current Asset Ratios • Fixed Costs and Long term Commitments

19. ERM IN SMALL Businesses Operational Risk Metrics in Restaurants Guest Check Averages Number of Seats QSC Scores Level of Ambiance Employee Turnover Ratios

20. ERM IN SMALL Businesses Operational Risk Metrics in Restaurants Management Turnover Ratios Number of Seat Hours Number of Transactions (Covers) Number of Transactions per Ops. Hour Longevity of the Business Terms of Lease

21. Risk Metrics and ERM in Restaurants Expected Outcomes • Lower Failure Rates • Improved Success Rates within a System • Caution Notice for Potential Failures • Proactive Strategies when at Risk • Comparative Analysis • New Market Analysis for Risk • New Location Analysis for Risk

22. Risk Metrics and ERM in Restaurants Expected Outcomes • Lowering of Financial Risks • Improved Investment Decisions • Improved Operations • Good Public Policy – helping small businesses • Good Private Decisions – financial & operational

23. Where Do We Go From Here? • Need to expand the Goldenson Center’s ERM-SB initiative in order to make an impact in the Restaurant Industry or other business sectors • Any large scale implementation should be supported by a large organization, corporation, private foundation and government agencies and not necessarily by a small business • Most cost-effective way to undertake these projects is to partner with academic institutions and engage students at universities all over the country

24. towerswatson.com Where do we go from here cont’dERM text for Small & Medium-Sized Enterprises (SME’s) • Approached by Actex publishers to write text • No such text currently exists in the ERM literature • The SOA has expressed an interest in funding this text from their 2013 research budget • Articles will be contributed by experts in the field, both practitioners and academicians • If properly designed, this book could become a required text for students following the SOA ERM track

25. towerswatson.com Where do we go from here cont’dPotential Topics for text on SME’s • Underlying principles governing ERM for SME’s • Overview of SME’s in the US • Differences/similarities between ERM principles for start-up SME’s, SME’s in business for a few years and established SME’s • In-depth ERM analysis of some key SME business sectors based on actual case studies • Regulatory environment for SME’s and impact on failure rates of SME’s • Steps involved to undertake an ERM analysis for a given SME sector, including measuring and tracking results • General ERM principles and methodologies for large corporations which can be adapted for SME’s • Best practices to create a vibrant and growing SME environment in the US and the value of establishing a risk management culture for SME’s

26. Conclusion • The Goldenson Center has just scratched the surface in showing how an effective ERM culture can be created with small businesses • ERM-SB is a form of micro-risk management and can be replicated globally with funding from large corporations and other entities with university students doing the projects • To have an impact, ERM-SB should analyze and monitor an entire small business sector (e.g. restaurant industry, retail drug store industry, independent marketing organizations, etc) versus individual small businesses • Huge payoff since any reduction in the failure rate for small businesses would be a boost to the overall economy

27. Contact Information 1. Jay Vadiveloo, Ph.D, FSA, MAAA, CFA Professor-in-Residence & Director Janet & Mark L. Goldenson Center for Actuarial Research, University of Connecticut & Senior Consultant, Towers Watson jay.vadiveloo@towerswatson.com 2. H.G. Parsa, Ph.D., FMP Barron Hilton Chair in Lodging & Professor of Hospitality Mgmt. Associate Editor, Journal of Hospitality and Tourism Research (JHTR) Fritz Knoebel School of Hospitality Mgmt. Joy Burns Center 2044 E. Evans Ave Daniels College of Business University of Denver Denver, CO 80208-2100 (303) 871-4791 hparsa@du.edu