Introduction

Anyone familiar with classical finance theory understands that the trade off between returns and risk is a fundamental one. Most business activities use NPV as a measure for project feasibility and think that it sufficiently accounts for the risk involved in the project. This is not the case.

Nocco and Stulz give an example. Consider a business undertaking a project with $200 million NPV. A diversifiable risk from the investor’s point of view can cause a bad outcome to the business. Say, an unexpected spike in currency or commodity price causes a loss of $50 million for the project. This shortfall of $250 million will not only affect the market’s expectation of future cash flows and earnings for the business, but also affect launching of other positive NPV projects that need immediate funding (funding for which would have come from this initial project). This results in a permanent reduction in value for the business. This example clearly illustrates that there is an unmet need to manage risk. Enterprise Risk Management deals with how to assess risks in an enterprise, how to strategize and design execution plans and ways to measure and monitor risks during the execution.

Definition

Broadly, ERM is defined as the process of identifying major risks that confront an organization, forecasting the significance of those risks in business processes, addressing the risks in a systematic and coordinated plan, implementing the plan, and holding key individuals responsible for managing critical risks within the scope of their responsibilities.

Practice

ERM is much more than identifying risks and buying insurance to cover those risks. Here is another example. Prior to Feb, 2007, JetBlue Airways ranked very high on customer satisfaction with their low airfares and non stop flights coast to coast with a personal TV screen for every seat. On Valentine’s day, a bad ice storm hit JFK airport which happens to be a JetBlue hub. Many planes were stranded in the tarmac with thousands of passengers trapped. The aircrafts ran out of food, toilets overflowed. It was a mess. It took more than 6 days to clear the backlog after a loss of nearly $30 million. How could have ERM helped JetBlue?

The ERM program could have scanned for risk on a continuous basis to identify scenarios with a large downside. An ERM program could compute the odds of a bad ice storm hitting a busy travel day in New York. Even if the odds for this event is low, the severity if such an event happens is quite bad. The ERM program could then notify the JFK operations manager for JetBlue who could then arrange for standby bus service and other facilities to ensure that the customers are taken to a safe place in comfort. This would help keep their reputation of great customer service albeit at a small cost. This illustrates how an ERM program can help to prevent a crisis as opposed to providing an insurance post crisis.

Conclusion

This is a broad outline of what ERM is and how it can be used in your organization. As ERM has matured from its infancy, it has progressed from being a tool to handle crisis to becoming a strategy tool that guides the “C” leaders in an organization.