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Financial Services


February 28, 2006

Putting the Value into Enterprise Risk Management

New thinking on how to improve firms' use of ERM

Taking an enterprise-based approach to risk management is becoming an accepted practice at large financial institutions. Banks are arguably furthest ahead, while insurers, which have a high degree of complexity and multi-dimensional risk profiles, are often further behind. As enterprise risk management (ERM) programs are taking shape, it has become obvious that many firms are struggling to derive real value from these efforts. New ways of thinking about ERM can offer significant benefits to financial institutions in all sectors, especially insurers.

Perhaps the biggest problem with ERM programs has been a lack of quantitative rigor. It is difficult to make a business case for an ERM program or to support its individual decisions when it is not backed by a cost-benefit analysis. “In many financial services companies, the quantitative focus is only on capital,” notes Sim Segal, a senior manager with Deloitte Consulting LLP. “What is missing is a link between capital impacts and the primary metric of decision-makers – value. As a result, many companies are not fully able to embed the ERM process into key decision-making processes.”

Effective ERM is a multi-stage process that moves from establishing risk governance and an ERM framework to risk identification, risk assessment and risk response, followed by performance measurement/management and finally, external reporting. In the financial services sector, approaches to date have been too exclusively focused on the risk assessment phase. These companies often put the bulk of their ERM efforts towards calculating “economic capital” – the amount of capital needed, based on sophisticated risk modelling. While this effort can lead to significantly enhanced risk insights, without a connection to the impacts of risks on value, ERM efforts can stall early.

A better way to think about ERM is to begin with the concept of value. In this context, value is a company’s internal valuation, involving a multi-year projection of distributable earnings (which includes cash flows and capital flows) discounted at the weighted average cost of capital. A value-based approach to ERM takes the value of the firm as its starting point and assesses the impact of different risks on this value – both financial (e.g., market risk) and operational, such as the risk of not achieving planned growth.

By using this technique, a firm’s risk profile can be expressed in terms of value – how “shock resistant” the value is to risks to which the company is exposed. Each business decision can then be evaluated in terms of its net impact on enterprise shock resistance. “Now you have one metric – value – through which to express ERM, and value is something everyone understands and everyone must care about,” says Segal. “Not only does this build a bridge between ERM and decision-making, but it also provides a filter for an otherwise voluminous and disparate set of risk metrics that can overwhelm an ERM committee.”

To be effective, firms need to develop their ERM programs in a way that allows risk intelligence to be built into key decision-making processes. The next generation of ERM programs will get there, but only if the concept of value is put at the center of thinking and practice.