Executive Summary For Integrated Risk Management - Essay Example

Executive Summary The increasing cost of managing risk is taking its toll on risk managers all around the world. The legacy risk management systems are becoming obsolete, both because of their operational limitation and high premiums. The contemporary concept of an enterprise wide risk management system is being adopted by many multinationals around the world. A very good example is of Honeywell Inc. Honeywell has used an overall annual aggregate retention to manage its risks rather than using separate retentions for each risk. This does not only reduce premiums paid to insurance companies and investment banks but also integrates different functions of a multinational. Introduction World has evolved rapidly over the last few decades. The changes on our economic horizon are just a part of a global economic shift toward better more efficient and transparent systems. The term ‘better’ is a very generic term. This has been used basically to make a statement about diversity. The term ‘better’ changes its meaning every few years for everyone. For example a few years ago it was better to own an apartment in a high rise apartment building than an ordinary house. Today however the trend has changed once again. People prefer buying private houses rather than apartments; even the most expensive ones. This is because of a socio cultural shift in human evolution. This is just a very small example of the change that is present all around us. Another example if of the concept used mostly in International Business Management (IBM) called ‘International Product Life Cycle’. This concept basically assumes that a product exists in every phase of its life cycle if we look at the world as a whole. A very relevant example would be of a Plasma LCD. These LCDs are in the growth stage of their life cycle in developed countries. In other developed countries however they might still be in the introductory stage. This is just an example of the complexity and diversity that is present in our business environment today. This complexity and diversity makes decision making very difficult. The risk factor therefore becomes even more prominent and damaging. When every decision might be right and wrong at the same time, how can you minimize risk? Moreover a global business environment is order of the day. This means that there are very few large and successful corporations which are not multinationals. Going beyond borders has therefore become a recipe for success. Recently a new phenomenon has emerged called outsourcing. This basically includes using human capital, technology, raw material and intelligence of developing nations. One of the main reasons behind using out sourcing is the cost advantages achieved by buying cheap and selling expensive. The concepts such as outsourcing have increased the risks of doing business even more. A corporation every day makes thousands of different transaction with counterparts located in different countries around the world. These corporations have different currencies, interest rates and hundreds of different economic variables which affect their performance. A very small example is of exchange rate risk being faced by a corporation operating from USA. This exchange rate risk would exist for all the different business ventures going on which involve outsourcing. Boeing for examples ships thousand of different components daily into USA. An exchange rate risk exists for each of these imports. Moreover each foreign company has country risk and other systematic and unsystematic risks associated with their operations. The assessment of each specific business partner is impossible because of cost implications. These very reasons have increased the market for derivates which provide insurance against the uncertainty and diversity inherent in our business environment. The types of risks that can be faced by a typical multinational are as follow: Currency Interest rate Liquidity risk Pension fund Credit risk Hazard risk Legal risk Regulatory risk Market risk These mentioned risks are both managed through derivates and operational measures. Other risks which are managed through traditional insurance are as follow: Employee risk General liability Property Product liability Employee liability Automobile liability Ocean marine transit Workers compensation Legacy Risk Management Systems In multinational’s risk management roles have usually been carried out by the treasury departments. The approach to risk has been although incorrect. This is because risks have usually been treated separately for different categories. When you treat risk separately for each category it would usually mean that spate departments need to be set up for each category of risk. This is in fact a waste of more than man power and organizational resources. This is indeed a waste of risk management opportunities as we will further uncover. Derivatives and Insurance The legacy systems being used in organizations usually used three different departments for risk management. The credit risk and exchange rate risk are usually managed by the financial risk management department. The roles in departments managing such risks usually focused on hedging with derivates. These derivates include futures, options etc traded on exchanges such as CBOT and CME. The role of these derivates is to absorb risk of investors. If we take for example a currency future (let’s say GBP/USD) it gives a certainty that pounds could be converted into USD (at predetermined price) at an agreed future date. This would take away risk of increasing or decreasing USD rates for corporations. The contract however comes at a certain price and even if it’s not exercised that price has to be paid. Other risk management roles in a multinational are capital market and insurance risk management. The capital market risk management usually manages any liquidity risks associated with securities or other cash equivalents being held by the company. The insurance risk management involves managing risks associated with liability risks mentioned above. Value Creation The risk management perspective of value creation aims at minimizing losses. This is because losses inevitably reduce value. The value creation is therefore assed not only ROI and ROE but also by reduction in administrative expenses and options premium. This means that risk management also has the role of reducing the cost spend on minimizing risk. As mentioned earlier even if derivates are not exercised a number of costs are associated with their usage. These include premiums, brokerage costs and administrative expenses. Integrated risk management This is a new and revolutionary phenomenon in risk management. The concept is aimed at reducing costs of managing risk for multinationals. This concept is therefore only applicable for corporations with many different products and markets. As the diversity in markets and products increases the effectiveness of integrated risk management framework is also increased. The concept is basically borrowed from financial theories such as capital market theory. According to these financial concepts, each stock in the market has a beta, which shows its correlation with overall market movements. Betas of different stocks in the stock market make the beta of the market as a whole (i.e. 1). The beta of 1 according to portfolio management’s concepts would be a zero risk sate. In such a zero risk state all the unsystematic risk is removed from the portfolio. The systematic risk is although still present. This systematic risk is actually due to macro economic variables and cannot be diversified away. The enterprise risk management framework builds itself on these concepts. The entire set of risks being faced by a multination are considered as a portfolio. In such a portfolio risks will have both negative betas and positive betas. This will basically be dependent on correlations. Different risks with negative correlations will tend to cancel each other out. Such as system was proposed by Honeywell Inc. The idea behind their enterprise risk integration model was to create an innovative insurance contract. Under a multiyear policy such a contract can combine their traditional hazard risk with foreign exchange translation risk. The basic assumption behind this contract was that the total losses followed a probability distribution and that correlation between currency risk and insurance risk was zero. Therefore a singular insurance coverage policy can be established which has one annual aggregate retention rather than separate retention for each risk. This would not only reduce cost but integrate the business together. This integration is very important in a diverse business environment. From a purely strategic management perspective this would also provide the business with advantages of less reliance on outsourcing. The overall expenses on hiring and maintain administrative staff is reduced greatly. This is because the calculation and paper work for each insurance unit separately is much more expensive than overall. The method adopted can differ from organization to organization. If however we take a look at risk integration framework provided by Honeywell we can see that different categories have been redefined. A two dimension strategy incorporates the entire risks being faced by the company into two broad categories. The Product market risk has sub categories such as Input risk, Tax risk and regulatory risk. The second category defines the operational risks being faced by an organization. This broad category is divided further into Legal and financial risks etc. This whole process of integrating the risk management goes a long way into changing the perspective about risks. The managers of risk usually try to avoid taking risks. This however also means that important earnings are forgone because risk is not taken. The integrated management of risk approach motivates employees to venture into risky activities as long as these risks are balancing out other risks and thus bring down the risk of doing business. Conclusion The example of Honeywell Inc has shown that this system is effective in reducing cost of managing risk. The managers must take other measures as well such as flexible manufacturing, standardized product, diversification and using part timers to manage their risks. References Froot, K. David, S. Stein, J (1994). A Framework for Risk Management. HBR. Reprint 94604 Read More