The burden of risk management

Weighing perils is a heavier burden
By Andrea Felsted

From the financial turmoil to spiralling commodity prices, companies have never faced so many perils. The past few months have seen unprecedented events in financial markets, with a specialist in managing risk through insurance, American International Group, finding itself in crisis because of the risks it had taken insuring complex financial products.

With poor risk management at the heart of many aspects of the financial crisis, what counts as risk is being reassessed. More than a year on from the start of the squeeze on credit, many financial institutions are still aligning their risk management programmes with the new reality.

“In the old world, risk management was potentially a second-order reporting issue. In the new world, it is very likely that [everyone from] the chief executive downwards has to have a greater level of understanding of the real risks and the potential risks that an institution faces,” says Stephen Christie, a partner at Ernst & Young, the professional services firm.

Global financial shocks were high on a list of the top 10 strategic risks for business, second only to regulatory and compliance risks, according to research from E&Y and Oxford Analytica, the strategic consultancy.

Many financial services organisations are still adapting their risk-management programmes to the lessons learned from the crisis. ”Risk management is about continuous learning, because every time there is a crisis you discover new things,” says Raj Singh, chief risk officer at Swiss Re, the reinsurer.

The lessons being learned include understanding and measuring the risks within increasingly complex financial instruments. “The crisis has shown that it is far more complicated to measure risk than we thought previously,” Mr Singh says.

According to Clare Thompson, financial services risk advisory leader at professional services firm PricewaterhouseCoopers, fully taking the lessons onboard could be a lengthy process.
“It is quite a long haul for some organisations to really go back and look, and really understand, the risks they face,” she says.

Werner Grub, a founding partner of Richmond Park Capital, an independent merchant bank that provides risk-management advice, suggests there is a danger of businesses being slowed by excessive caution because of the recent turmoil.

“It is like a stop and go policy. Now we are in the stop phase which leads to a negative attitude, such as banks’ reluctance to lend to each other. There must be a rethinking of risk management, not relying only on quantitative analysis, but also going back to the qualitative, which often people considered as too unsophisticated,” he says.

Outside financial institutions the crisis in credit markets is also being felt, particularly as it mutates into a broader economic downturn.

It is harder for companies to borrow, while they also risk succumbing to the tactics of other companies that may be experiencing strain, such as delaying payments for goods and services.
Many are concentrating on the management of their working capital – the cash a company needs to operate on a day-to-day basis.

“What we are seeing a lot of at the moment is companies focusing on working capital management. Whether that is the creditor/ debtor balance or managing inventory, the common denominator is that companies are applying this to the decisions they make,” says Hans-Kristian Bryn, a partner at Oliver Wyman, the consultancy.
Companies are also turning their attentions to the hazards from a broader economic downturn – from an increased risk of being the victim of theft or fraud, to the impact on their balance sheets or pension funds from wild swings in equity markets.

Corporations are also having to cope with escalating commodity prices, although there has been some respite from this over recent weeks.

Sean Mulhearn, global co-head of commodities at Standard Chartered, the bank, says: “Almost all commodities have seen dramatic price increases over the past several years. We have also seen significant increases in volatility, and this is raising the awareness and importance of managing commodity risk among corporate treasurers and asset managers.”

Techniques that companies can use to protect themselves against the risks of commodity prices include hedging through derivatives, or passing increased costs on to customers.

Broader inflationary pressures are also occupying risk managers’ minds.
Mario Vitale, deputy chief executive of global corporate at Zurich Financial Services, says inflation affects the amount of insurance cover on property and equipment, for example.

“Today’s risk-management programmes will be different even from a year ago. There will need to be a much closer analysis of what is the proper replacement value to insure for,” he says.
As companies expand outside their home markets and into new territories, life becomes even trickier.

Corporations are increasingly outsourcing non-core operations to third parties, often in offshore locations, or are shifting manufacturing to locations with a lower cost base. Cheaper locations may face an increased risk of natural catastrophe or political instability. Companies must also take the resilience of suppliers into account when they make decisions about sourcing.
“The further you go down the food chain, the more likely you are to have organisations that fall over,” says Mr Bryn.

Indeed, Charles Beach, a director in PwC’s risk and capital team, cautions that a focus on the financial crisis could blind companies to risks in other areas.

“One of the things we have been warning against is the tendency to always fight the last war,” he says. “Whilst people are looking at the subprime crisis, which emanated originally out of the US and has been a first world crisis, there has been continuing huge growth in emerging markets, in places such as Asia. One of the things we have been warning against is taking your eye off the ball there.”

But Julia Graham, chairman of the Association of Insurance and Risk Managers (Airmic), says: “It is a very good risk control being a global business. If you can spread your risk globally, that is actually, obliquely, a very nice risk-management control.”
She says some organisations are shifting emphasis, for example focusing on the Middle East, or parts of Asia, rather than the US.

Companies are under increasing pressure to manage their risk effectively. For example, Standard & Poor’s, the credit ratings agency, is now taking risk management into account when it decides on a company’s rating. But inevitably, in a harsher economic environment, there will be pressure to cut costs.

Richard Sharman, a partner in KPMG’s risk advisory services group, says: “Now really is the time to be looking at that investment and making sure it is adequate. It may be you need to spend less, but for many companies it means you need to spend more on risk management.”
Risk management not only protects against unwanted events – it also helps identify opportunities and deliver value for shareholders. In tougher times, both are more crucial than ever.
“If you do [risk management] better you are more likely to survive than the business next door to you,” says Airmic’s Ms Graham.
“Risk management is about looking over the hill. But a lot of boards look at the hill, not what is over it. One of our jobs is to make sure they keep looking beyond, and not just at what is in front of them.”