In the best interest of policyholders
Enterprise risk management (ERM) can be much more than just a way to avoid accidents, especially for construction and manufacturing firms. ERM doesn't just emphasize safety and financial stability. Rather, the vast majority of risks companies face are strategic in nature, which is why Amerisure's policyholders might consider a robust ERM program as opposed to a set of simple financial controls only.
How does a company apply an ERM program? One method is to identify and assess the risks facing the organization. Then, it is necessary to quantify the exposure the risks have to the organization, develop mitigation strategies for those exposures and consider the cost-benefit analyses associated with various mitigation options. Communication is important – the entire risk profile has to be vetted with leadership teams, as well as all relevant groups within the organization.
When an organization fosters an environment of risk-based decision-making, companies can use risk tolerances to quantifiably articulate their capacity for assuming risk. Following the financial crisis of 2008/2009, the banking industry, which had utilized risk tolerances, shared best practices to help other companies get started. With risk tolerances in place, an organization can then best optimize their risk profiles. Overall, this allows them to experiment and figure out exactly what type of risk-taking organization they are.
ERM in action
The construction industry provides countless opportunities in which ERM can add value. For example, a construction firm specializing in bridge construction may have two large cranes in its fleet inventory. The firm is aware of several key "knowns," such as the fact that it takes a given number of work days to tear down, move, and re-erect a large crane. Another "known" might be the daily penalty fee the construction firm must pay for each day a project extends beyond its final deliverable date. Finally, the firm will consider its feeling for how many projects it can comfortably bid into the future – a "known" despite the fact that it truly is an estimate based on past experience. Given this information, one might ask how ERM can play a value-added role. Risk tolerances help answer that question.
Were the construction firm to employ an ERM program, the firm would express, among other things, its target for how many future projects it will bid on while the cranes are deployed on another project, as well as its target annual net profit margin. The firm would then set tolerances around these respective targets.
For instance, if the firm's target for future project bids is one, then tolerances might be zero on the downside and three on the upside. This means the firm will try to target the submission of one bid on a future project while its cranes are otherwise deployed. The firm's tolerances express its desire to remain busy booking future projects while not overextending itself in the event of project overages, which may continue to require the services of the cranes (thus causing delays on the firm's next project and exposing the firm to a heightened risk of paying penalties if the next project doesn't finish on time). The firm's downside tolerance means the firm will still be comfortable with not submitting a bid on a future project while its cranes are otherwise deployed. The upside tolerance states the firm's discomfort with bidding on more than three future projects while its cranes are otherwise deployed.
The firm's net profit margin target may be 15 percent, with a downside tolerance of 9 percent and an upside tolerance of 25 percent. As it proceeds through business cycles, the construction firm must balance its risk tolerance for bidding on future jobs while its most important resources – the cranes – are otherwise deployed, while at the same time striving toward its target net profit margin. If the firm cannot reconcile a 15 percent net profit margin with bidding on only one future project at a time, then it must re-assess its targets. If the firm finds that bidding on three future projects still only helps it generate an 8 percent net profit margin, then it must re-assess whether it is comfortable lining up more future projects or accepting a lower net profit margin. Either way, the tolerances must be aligned to realistically manage the firm's true risk profile.
As an important aside, many who are new to ERM ask why a firm would want an upside tolerance when considering something like net profit margin. After all, isn't it better to make more money? The answer lies in risk tolerance. If a firm reasonably expects to generate a 15 percent net profit margin, then that firm seems to be comfortable assuming the business risks associated with that 15 percent net profit margin. It's fair to ask, shouldn't that firm then wonder what risks it has been assuming if it turns out the firm has generated a 50 percent net profit margin at the end of the year? If the original target of 15 percent was truly reasonable, then it would be fair to presume the firm assumed a much greater amount of risk in order to earn an additional 35 percent net profit margin.
What if the additional risk assumed to generate the additional 35 percent net profit margin was a "make-it-or-break-it" risk? In other words, if everything works out fine, then the firm would hit a home run and earn an additional 35 percent net profit margin. However, if everything doesn't work out fine, then the company would go into bankruptcy. This is an example that can be likened to "betting it all on black". This certainly does not describe enterprise risk management.
Ask yourself, would you rather run your business like you're gambling at a casino, or would you rather take calculated risks which you know to be consistent with your established risk tolerance?
This article is part two in a series on enterprise risk management.
